Market Overview

What's Facebook Stock Worth?

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Facebook Inc (NASDAQ: FB) has great growth potential and has been well managed to date. The current price of $82.05 assumes continued strong growth in the long term, a difficult time frame to forecast for a web-based service that is likely to evolve substantially in coming years.

Prudena's models illustrate just how much speculation is involved in the current valuation of FB shares. 

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Prudena's models assume continued strong growth for Facebook and take some very bullish inputs. Assuming an 8.0% required rate of return, the current market price of $82.05 implies 6.99% long term residual earnings growth. This is an exceptionally high implied growth rate, but it is unsurprising for a tech firm in its growth phase.

Forecasting EPS growth in excess of 25% over the next 5 years and consistently topping 10% in the long term, Prudena's residual earnings model estimates $65.36 in value per share.

A Monte Carlo simulation based on that residual earnings model while accounting for future income uncertainty, assuming long term residual earnings growth between 5.5% and 7.5%, estimates a most likely value per share of $62.90. Similarly likely outcomes of the Monte Carlo simulation include prices as low as $57. The current price of $82.05 falls within the distribution of values from the Monte Carlo sim despite being 26% higher than the most likely value.

Investors should note that simple residual earnings models are inadequate tools for analyzing valuation of a growth company. However, Prudena's models are very useful for fundamental investors seeking to isolate the role of speculation in valuation and assess the implications of that speculation.

Try your own FB model!

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The Bull Case

Facebook has successfully transitioned towards a mobile platform. The company’s monetization on mobile is even more efficient than the desktop version of the site. Facebook is still managing double digit user base growth, largely in emerging markets. During the first quarter of 2015, the company’s monthly active users (MAUs) grew 13% on a year over year basis; daily active users grew 17% during the same period. More than 86% of Facebook’s traffic is coming from growing mobile space. This makes Facebook a very attractive proposition for advertisers going forward. According to reports by PwC, the internet advertising industry will reach $240 billion by 2019 at a 12.1% CAGR. Video advertising is expected to grow at 23.8% during the same period.

Increasing penetration of internet users across the globe and rise of connected devices are creating growth opportunities for Facebook. As a web scale player, Facebook will also benefit from technological innovations which make data storage and transmission less expensive. Facebook's earnings are high quality, evidenced by $1.5 billion in quarterly operating cash flow generated by the company.

Further, Facebook has the leading gross margin among its peer group. Facebook has also acquired certain companies, such as WhatsApp and Oculus, which can be strong growth drivers in the future.

The Bear Case

While Facebook's network effect generates a substantial barrier to entry, there are competitors in the social network space. Google has thrown its hat in the ring with Google Plus, though the success of this venture has been muted. Snapchat has continuously gained users while adding functionality. Twitter (NYSE: TWTR) has some overlap with Facebook's functionality and both companies will likely grow into similar spaces. As Facebook relies increasingly on emerging markets for growth, there is concern that the current ARPU is unsustainable. ARPU tends to be much higher in North America and Europe than in Asia-Pacific.

The strongest bear case to be made against Facebook centers on its rich valuation. Price-to-Sales of 16x is high relative to competitors. For reference, Google's (NASDAQ: GOOGL) P/S ratio is 5.35. FB stock is trading 60x 2015 consensus GAAP earnings. This results in a PEG ratio at about 2.3, a level that is usually considered high.

These metrics show that the market is assuming long-term growth and industry dominance, and web-based services can fall out of favor much more quickly than more traditional businesses.

Conclusions

Facebook has performed very well in recent years and continues to grow quickly despite its enormous scale. The company has been especially adept in adjusting to the rise of mobile traffic, which has proven to be a better source of marketing income than traditional PC display ads. Growing demand for video content and improving ability to deliver video represents a major opportunity for advertising revenue growth, as these sorts of ads will generally be more engaging during the average user's 30 minutes on Facebook each day.

Facebook is a clear market leader with substantial growth prospects.

Despite all of the historical and forecast success, shares may be too expensive to buy. Prudena's models show that the rich valuation does indeed entail significant speculation. While a simple residual earnings model is not sufficient for analyzing the share price of a growth phase tech firm, fundamental investors can use Prudena's tools to understand the assumptions implicit in the market price. 

About Prudena

Contributors: Soid Ahmad and Ryan Downie

NOTE: The Morning Monte is high-level, and any investment requires a deeper analysis than is presented here. The comments in the Morning Monte are intended to help guide your research and ground you in the fundamentals of the company. In no way should the comments in The Morning Monte be taken as advice to buy or sell a particular equity. Some of the statements are forward looking. As such, these statements are speculation--so beware! The comments represent the views of the author and are not necessarily the views of PRUDENA™.

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