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Facebook Inc will continue to face headwinds in coming months.
Shares of Facebook Inc (NASDAQ:FB) have been battered since it emerged that the company has allowed private data of over 50 million users to fall into the hands of Cambridge Analytica, a political consulting firm with ties to Donald Trump’s presidential campaign. Since the news came to light, Facebook stock has corrected by around 18%, wiping off over $70 billion from the company's market cap. Over the past year, while stating our long-term bullish stance on Facebook stock, we warned investors that there is a lot to be cautious about in the short term. The correction has led to many investors asking the question whether Facebook stock is a good buy right now? In this post, we will discuss the merits of this argument.
As we all know, the value of a stock is dependent on two crucial factors, free cash flows and discount rate. Free cash flows have a positive impact while discount rates have a negative impact on the stock price. Any event which impacts either of the two variables in turn also impacts the stock price of the company. The user data leak scandal definitely affects both the discount rate and the cash flows of Facebook. If data is the new oil, Cambridge Analytica fiasco is equivalent to a massive oil spill which will have repercussions for the company, in terms of cleaning up the mess, paying for the damage done and imposing extra security measure.
Facebook now carries higher risk.
One of the key determinants of the discount rate of a company is the risk level. Riskier a company, higher the discount rate. The recent events have definitely increased the risk associated with Facebook. Facebook, which was already in the regulatory crosshairs for the Russia controversy, is facing renewed scrutiny from the lawmakers. CEO Mark Zuckerberg is expected to testify before the Congress. The regulatory risk has definitely increased over the past couple of months.
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. There have been calls for Facebook to extend these rules globally, but the company has declined. However, the days are not far off when other jurisdictions will adopt similar laws targeting the use of personal data.
Data protection laws could lower the company's potential.
Restricted use of personal data is bound to impact Facebook's ad targeting abilities and in turn its cash flows. There are concerns that Facebook's business model, which relies on the use of private data, may itself be broken. Though we believe it would be impertinent to pen down an obituary just yet. Facebook has also announced several changes to how third parties can access its data and use it for ad targeting. Facebook has already announced that operating expenses will grow between 45%-60% this year as compared to around 37% in FY17 on account of company's effort to tackle fake news problem. Add to it, the Federal Trade Commission has confirmed that it has opened a nonpublic investigation into Facebook's data privacy practices. This raises the risk of civil penalties on data privacy violations.
The scandal had also led to a massive public backlash across the globe with activist demanding tighter regulation of social media companies and collection and use of private data. There is also a #deletefacebook campaign encouraging users to get out of Facebook. While the campaign had garnered huge public attention, it is difficult to ascertain how many users walked away from Facebook due to this campaign. Though the campaign still persists, data from Google Trends suggests that the campaign peaked around March 24th.
Facebook stock is a good long term buy.
Clearly, the scandal will have a negative impact on the company's cash flows and risk perception and should impact its valuation. The question now is whether the correction in the stock is overdone? Facebook stock currently trades at a PE ratio of 28.9x, one of the lowest in its public trading history, while S&P 500 is currently trading at a PE of 24.66x. Looking at Forward PE, Facebook stock trades at 17.7x, 5% higher than S&P 500 forward PE of 16.85.
On the other hand, Facebook’s revenue is still growing more than five times as fast as revenues underlying the S&P 500, and its profit margin is three times as high. This clearly indicates that the correction in Facebook stock is overdone. Facebook still remains a clear favorite of advertisers and users too are not leaving in hordes.
To be sure, Facebook is not out of the woods yet. The company will continue face headwinds in the coming weeks. However, the long-term prospects still remain good. As we have discussed earlier, Facebook has several growth drivers which will help the company deliver results in the coming years.
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