With all the recent controversy surrounding Facebook, today we are going to analyze Facebook’s business fundamentals, growth potential, risks, valuation, and ultimately decide whether or not it makes sense to be a shareholder of the social media giant. Unless stated otherwise, all numbers and statistics presented below are as of August 7th, 2019.
The social media market
With over 2.41 billion monthly active users across Facebook and Messenger platforms, and over 2.7 billion monthly active users across all Facebook-owned platforms (including Instagram and WhatsApp), Facebook is a major player in the social media market, to say the least. Facebook is often accused of being a monopoly, but they do face fierce competition on many of their products and features. Messenger and WhatsApp compete head-to-head with Apple’s iMessage and FaceTime in the messaging and private communication space. In the video space, Facebook Watch and Instagram’s IGTV both pale in comparison to Youtube. However, Facebook’s network effect does provide an enormous competitive advantage in the social media space, largely owing to their extraordinarily enormous user base. Firstly, it increases the “stickiness” of users. If you live in a developed country, chances are that you and many your friends rely on a Facebook-owned platform as a primary channel of communication, making it very inconvenient for anyone to leave the network. Once hailed as an archetypal Silicon Valley success story, Facebook has taken severe blows to their reputation after a series of privacy scandals. However, users are not leaving the platform. In fact, monthly active users have continued to grow steadily following the Cambridge Analytica scandal that first began reshaping public opinion around the social media giant. Users stick to the platform, perhaps because there is no other feasible place to go. Secondly, an enormous user base gives Facebook a huge advantage over other social platforms. For example, when Instagram decided to implement “Stories”, a feature that had existed on Snapchat for over five years at the time, Snapchat was quickly out-competed. In less than one year, Instagram Stories had overtaken Snapchat Stories in active users. After two years, Instagram Stories had over twice as many users as Snapchat Stories, and Snapchat began to see a decline in users. This example demonstrates that when Facebook decides to enter a new space, they bring along an enormous existing user base, which gives them a competitive edge over smaller platforms.
The digital advertising market
Facebook in its current form is a social media platform, but it is in the business of digital advertising. It competes with the likes of Google, Amazon, Microsoft and Verizon in the digital advertising space, as well as everyone in the traditional advertising space, since money spent on traditional advertising is money not spent advertising on Facebook. Fortunately for Facebook, digital ad spend as a proportion of total ad spend in the United States is trending upwards. In fact, it is expected that digital advertising will account for over half of all ad spend in 2019, making it the first year that advertisers spend more on digital media than traditional media. It is not difficult to see why advertisers are moving from traditional media to digital media. Digital advertising often provides higher conversion rates and more impressions at lower costs, ultimately producing a higher return on ad spend for marketers. Facebook can provide more effective advertising because their ad targeting is laser-focused. Where traditional media can make their best guess that your ad will be shown to 18-24 year old females in New York who are interested in beauty products, Facebook can be relatively certain of it, based on information that users provide them directly, as well as data that is collected through users’ activity both on and off the platform. They can also offer lower rates to advertisers due to the vast amount of ad inventory provided by their enormous user base. Additionally, digital media platforms typically provide better tools for ad campaign monitoring and analytics, which is important for marketers. With digital media, marketers can collect data in real-time and make changes and optimizations to their ad campaigns within minutes. This gives digital media an edge over traditional media, and Facebook is well-positioned to benefit from the inevitable shift from traditional to digital. Facebook currently sits at around 19% of total digital ad spend in the United States.
Facebook’s competitive advantage lies primarily in three areas: user base, data, and business success. As mentioned before, their vast user base creates a network effect that makes it extremely difficult to leave and tempts new users to join. Facebook has to spend relatively little to acquire new users in their established markets (which is most of the developed world), making them very difficult to compete against for new startups that have relatively high customer acquisition costs. Additionally, Facebook’s data advantage allows them to create highly accurate and detailed profiles on their users, giving them a huge competitive edge over traditional media platforms and even other digital media platforms. Finally, despite being caught in political crosshairs, Facebook’s vast profitability allows them to be relatively resilient in a hostile regulatory environment. Unlike Snapchat and many other tech startups that are not yet profitable and require constant capital injections from investors to sustain their operations, Facebook is a cash-generating machine. New legislation regarding privacy and security will likely be introduced in the near-future, and compliance often requires an increase in headcount as well as infrastructure modifications, which can cost significant amounts of capital. Therefore, smaller and less profitable institutions would be disproportionately affected by new regulations, assuming that the regulations are broad-reaching and do not single-out Facebook as the target.
Facebook’s financial statements are the kind that Wall Street dreams about. Their balance sheet is pristine, with almost $50 billion in cash and only $13 billion in current liabilities, resulting in a cash-ratio of 3.75. Less than 25% of their assets are funded by debt, so they should face relatively less pressure during an economic downturn. Over the past five years, their earnings have grown over 600%, and they are continuing to grow, albeit at a slower rate. In the past twelve months, average revenue per user has grown by 18%, while total users have grown by 8%, leading to a revenue growth of 28% year over year. However, expenses are also ramping up as Facebook faces regulatory pressure to make improvements to their privacy and security infrastructure. As a result, operating margins have fallen from 44% in the second quarter of 2018 to 39% in 2019, leading to a modest operating income growth of 13% after adjusting for the recent fine from the Federal Trade Commission. One would hope that Facebook can eventually reduce the costs required to improve their infrastructure, as well as overcome the regulatory obstacles as to avoid excessive fines and settlements in the near future. Ideally, they would be able to do this while maintaining strong revenue growth, which does not seem to be a problem at the moment. This is particularly astounding considering the already-gargantuan size of Facebook.
Despite having over one-third of the world in its network, Facebook’s user count continues to grow at high single digits, although most of this growth comes from regions where Facebook does not monetize quite as well, such as Asia-Pacific and “Rest of World”. In these regions, the average revenue per user is less than one-tenth of that in the United States and Canada. However, this presents a macroeconomic growth opportunity for Facebook – as these countries grow their economies, consumers will spend more and advertisers will spend more to attract these consumers. Therefore, in addition to a steadily growing user count in these markets, with time, the value of each user in these markets should grow too.
More macroeconomic growth potential lies in the year over year expansion of the global advertising market. Total advertising spend worldwide grows around 5% each year, and as mentioned before, digital advertising is taking a larger and larger portion of that spend. As a market leader in the digital advertising space, Facebook is well-positioned to benefit from these two macroeconomic trends.
Aside from macroeconomic tailwinds, there are still many adjustments that Facebook can make to its platforms to improve their top-line. In fact, much of Facebook’s growth limitations are self-imposed. Facebook is very conscious about the user experience and is aware of how it can be impacted by advertisements. Therefore, when rolling out new ad products such as Facebook Stories ads, they will likely take their time and exercise caution, often testing out the feature in small markets and expanding slowly until they are confident that it will not impede too much on the user experience. Surprisingly, there are still no ads on Instagram’s Explore Feed. Additionally, Messenger and WhatsApp are barely monetized. Each of these present opportunities to increase ad inventory, but we can expect Facebook to be patient and to roll out new ad products on these platforms slowly over time.
Facebook is constantly releasing new products such as Libra, Facebook Marketplace, Facebook Dating, Facebook Watch and Instagram Checkout. If successful, such new products may meaningfully contribute to their top-line. Like Google, Facebook is also willing to make a few moonshot bets on new technology such as virtual reality headsets and augmented reality glasses. Only time will tell whether or not these investments will pay off.
Currently, Facebook’s biggest and most obvious risk lies in the current hostile political environment in which it operates, both in the United States and worldwide. The European Union has been constantly hammering on the tech giants for their privacy issues and anticompetitive behavior, implementing policies like GDPR and aggressively attacking them with fines, which, if continued, may have a materially negative impact on Facebook’s profitability. Additionally, the United States government has also begun to take legal action against the tech giants, with bipartisan support. Facebook recently received a $5 billion fine from the Federal Trade Commission and is currently pending investigation from both the Department of Justice and the Federal Trade Commission for potential anticompetitive behavior. The results of these investigations are to be seen, but any antitrust actions taken against Facebook could materially impact its operations.
Additionally, although the recent series of privacy and antitrust scandals have not seemed to meaningfully impact user count, it has seemed to negatively affect employee morale at Facebook. Surveys completed by employees at Facebook have not been as positive as in the past, and the company has seen ten of its top executives leave in 2018. If this trend continues, Facebook may find it difficult to attract and retain top talent and lose some of its competitive edge.
The following discounted future earnings model makes the following assumptions: Facebook’s earnings will grow at 15% year over year for five years starting January 2019; it will have a price/earnings ratio of 16 at the end of this period; and the investor demands an 11% annualized return during this period. Discounting future earnings under these assumptions, Facebook’s present value is $422 billion. It’s current market capitalization is $550 billion, meaning that the stock is currently overvalued under these assumptions. However, any model is only as good as its inputs, and even a small change in expected earnings growth, terminal price/earnings ratio or discount rate could have a significant impact on the present value. Whether or not you should to invest in Facebook at these prices will depend on your own expected future value and required rate of return.
Facebook is a remarkable business that has grown its revenue and earnings at an extraordinary rate over the last few years. There is still plenty of room to grow, but whether or not the growth materializes will depend on macroeconomic factors, regulatory outcomes and Facebook’s ability to effectively execute on their vision. Facebook’s fundamentals are strong, but with an adjusted price/earnings ratio of 24, and a price/book value of 6, it seems that this strength is already somewhat reflected in the market value of the stock.
Disclaimer: Consult your financial professional before making any investment decision.