Headwinds Remain, But Facebook Stock Still A Good Buy

Facebook Inc remains the most reliable platform for advertisers.

The market outlook has changed pretty quickly for Facebook Inc (NASDAQ:FB). Just over a month ago, lawmakers were hauling Facebook for not protecting users data. Apart from the regulatory scrutiny, investors were worried about user boycott and advertisers' backlash which could have dented the Facebook story. Users were calling for a boycott of Facebook, with #deletefacebook trending on social media sites. All those worries were put to rest by the company's latest earnings results. Revenues and profits surged past analysts expectations. Facebook stock has surged by over 10% since earnings.
FB stock chart

FB stock by kartofel-pro.ru

Nowhere to go.

Despite all the hype around #deletefacebook, the social media giant saw growth in both, the number of users as well as user engagement. MAU and DAU grew by 13%, in line with the recent trend. It turns out Facebook is more important part of our life than we thought it was. And many are willing to trade their private data for access to the social media platform. Advertisers too continue to see value in Facebook's ad targetting abilities and its over two billion users. Demand for Facebook ads continued to outstrip supply, leading to significant increase in average price per ad which increased by 39%, higher than the previous quarter growth. The trend in Facebook's average price per ad clearly shows that advertisers do not have any other alternatives.

Headwinds remain

This is not to say that the recent scandals have had no impact on Facebook's business. Facebook will continue to face scrutiny for its data management practices. User engagement may see a dip going forward. The regulatory environment is around data usage and sharing is also evolving. European Union has already brought out a law known as the General Data Protection Regulation (GDPR) for stricter regulation. The law which is billed as the biggest overhaul of online privacy since the birth of the internet will give Europeans more protections for their data than ever before. Other companies might follow suit. Restricted use of personal data is bound to impact Facebook's ad targeting abilities and in turn its revenues. Facebook is also investing in curbing fake news which will lead to a decline in its operating margin.

However, Facebook story remains intact to a large extent. Growth in online advertisement spending coupled with Facebook's huge user base will continue to deliver high ROI for advertisers. Other properties including Instagram and WhatsApp will also start contributing significant revenues. Instagram already contributes billions of dollars to the Facebook topline. Facebook has done well to keep Instagram and WhatsApp out of the current scandal, keeping their brands intact. All in all, Facebook will continue to deliver strong revenue growth and high operating margins.

Facebook stock valuation

A discounted cash flow analysis shows that Facebook stock is still a good buy despite the recent headwinds. For the DCF calculation, I have used initial WACC  (Weighted average cost of capital) of 9.6%. Sine Facebook is zero debt company, its cost of capital is equal to its cost of equity. The table below contains the key values used for arriving at the final WACC value. We have used 10 year US Bond as the risk-free rate and calculated five-year regression beta.

Facebook cost of capital

1) We have assumed that revenue growth will continue to decline over the ten year period. Given the recent controversy, we expect revenue growth to slow down to 40% in FY 18. We have assumed terminal revenue growth of 3%

2) We expect a similar trend in operating margins also. With rising spending on fighting fake news and investment in data protection, Facebook's margins will come under pressure. We expect operating margins to decline from 50% in 2017 to 40% over the next ten years. On the other hand, we expect Facebook's marginal tax rate to rise to 25%. In the first quarter of 2018, Facebook's effective tax rate was 11% similar to previous quarters. FY 17 Q4 was an outlier as Facebook was forced to recognize billions of dollars in provisions due to the new tax law.

3) We have based Facebook's reinvestment needs on its sales to capital ratio, a measure of capital efficiency. In FY 2017, Facebook's sales to capital ratio was 1.25. We have assumed it to remain constant over the forecast period.

Facebook stock valuation

The DCF valuation shows Facebook stock still has upside left. We will arrive at similar conclusion if take the relative valuation route. Facebook stock is currently trading at a forward PE of 19x, which is higher than S&P 500 (INDEX:SPAL) forward PE of 17x. However, when you bring revenue growth and operating margin in picture Facebook stock appears to be relatively cheap.  2018 estimated S&P 500 earnings growth rate is now 17.7%, in comparison Facebook's earnings is expected to grow at 40%. All in all, Facebook stock looks a good buy right now.

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Neither waldorf-kras, nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice.

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