Facebook earns close to 99% of its revenue by advertising. Marketers pay for ad products based on the number of impressions delivered or the number of clicks done by users. The business continues to impress me given that my friends, family and colleagues are so hooked to the platform and most of them (albeit to varying degrees) can’t wait to give the lurking marketers access to their personal information at the expense of getting connected and endorsed (for posting their views/sharing pics etc etc you know it) with their network. I will cast aside my prejudice and value Facebook in this post.
First some facts
As of Sept’19, the platform reported to have 2.4 billion monthly active users world wide, which is 32% of the world population. FB earned an average of $28 per user over the the last 12 months (as of Sept’19). This translates to 4x growth in per user revenue since 2013 and ~3x since 2014. The platform draws $130 per user from US and Canada, followed by $41 per user from Europe (which includes Russia and Turkey), $12 from Asia and $8 from Rest of the world (which includes Africa, Latin America and Middle East). Although, US and Canada have the highest per user revenue, they account for only 10% of the user base.
Moreover, FB makes $11.6 as pre-tax operating profit on a revenue of $28 per user. This translates to a pre-tax operating margin of ~42% after capitalizing R&D expenses.
Valuation
Before jumping into valuation, let’s do a quick refresher on how a company is valued. Value of a firm is the present value of its projected Free Cash Flows (FCF). FCF is the the portion of net operating profit after tax that is left after meeting the firm’s reinvestment needs. So to value a firm, one needs to project operating profit (i.e. revenue x margin%) and reinvestments 5-10 years out (and discount them to present using the firm’s cost of capital).
Facebook story is that of an active user growth play. I go on to value FB under 3 scenarios using different revenue projections based on combinations of user base (as a %age of world population) and average revenue per user (ARPU). In all the 3 scenarios, I take the same margin, reinvestment cost of capital and return assumptions as follows –
- Margin: I assume that the current margin will drop from 42.05% to 40% over the next 10 years. Your estimate of future margins may be higher or lower, but I believe the status quo will more or less continue which is reflected in the 2% margin drop that I have assumed.
- Reinvestment: Again, I believe the existing state of operations will continue leading to the firm operating at current capital efficiency of 1.31 (i.e. FB generate $1.31 in revenue for every dollar invested) 10 years out. Capital efficiency ratio is used estimate reinvestments (Reinvestment = Change in Revenue / Cap Eff).
- Cost of Capital: I have used 8.3% as the cost of capital which gradually reduces to 8% over the 10 year period.
- Return on Invested Capital: Given the unwavering user engagement the platform has demonstrated, I believe that marketers will not pull out anytime soon and the platform will continue to increase the size of the digital marketing universe. The firm will continue to have competitive advantage and create value beyond year 10. With this belief, I assume an ROIC greater than the cost of capital beyond year 10.
1. Sane Scenario – I project user growth with the belief that FB’s active user base reaches 35% of the world population over the next 5 years from 32% today. This leads to the addition of 400 million new active users over the next 5 years which is under 40% of the new users addition over the last 5 years. Moreover, I make ARPU growth rate projections with the belief that ARPU will increase by ~1.75x in the next 5 years. (Overall ARPU has increased ~3x from $10 to $28 over the last 5 years). A combination of this ARPU and MAU growth (ARPU x Active Users = Revenue) leads to an implied revenue CAGR of 16% over the next 5 years, which is 40% of the growth over the last 5 years.
2. Upbeat Scenario – Letting my prejudice towards the platform flow in, I project user growth with the belief that FB’s active user base reaches 40% of the world population over the next 5 years from 32% today. This leads to the addition of 790 million new active users over the next 5 years which is under 75% of the new users addition over the last 5 years. Moreover, I make ARPU growth rate projections with the belief that ARPU will increase by ~2x in the next 5 years. (Overall ARPU has increased ~3x from $10 to $28 over the last 5 years). A combination of this ARPU and MAU growth leads to an implied revenue CAGR of 20% over the next 5 years, which is half of the growth over the last 5 years.
Using the above revenue growth projections, the value of equity in common stock I estimate is ~$722 billion which is over 20% of its market cap as on 12/31/19. The intrinsic share value that I get is ~$247 as against its current trading price of ~$205
3. Downbeat Scenario – In the event that FB’s active user base increases at the same rate as the world population i.e. active user base remains at 32% over the next 5 years and ARPU grows ~1.6x, this yields a revenue CAGR of 12 % over the next 5 years.
Conclusion
Not letting my prejudice overpower, my story of Facebook is centered on the “Sane” scenario, which makes the platform undervalued by 10% as of this writing. For long, I have made this business earn of me as an active user of the platform, now I will be looking to own a few shares if the price offers more than 10% of the value I have estimated in my story. Your story may be more “upbeat” or “downbeat”. The value that FB offers depends upon your story.
Thank you for reading!
Gautam
Disclaimer – Currently, I do not own any stock of this company. This analysis should not be misconstrued as a buy / sell recommendation. Readers are advised to do their own analysis. Moreover, any opinion expressed in this blog post is solely my own and does not represent views of my employer