Tags: facebook | FB | stock price | investing

David N. Frazier: In Spite of Recent Growth, Stock Market Participants Seem to Be Overvaluing Facebook Stock

By    |   Friday, 30 May 2014 11:14 AM

I’m sure you’re familiar with social media powerhouse Facebook (FB), which more than a billion people around the world use on a regular basis to communicate with their family and friends, but you might not know how the company generates its revenues.

So, before discussing my analysis of Facebook and whether or not I think you should buy the company’s stock, I’ll cover some general information regarding Facebook’s business model.

In leveraging the Menlo Park, California-based company’s 1.2 billion monthly active users, Facebook generates a substantial majority of its revenues from selling advertising on its web sites and mobile applications to businesses that are seeking to increase their sales and to build awareness of their products and services.

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Unlike the offerings provided by many marketing communications entities, businesses that advertise on Facebook can target their ads to people based on demographic factors such as age, location, gender, education, and specific interests that are provided by the company’s users. Facebook's ad serving technology determines the best available advertisement to show a user based on the combination of the user's unique attributes.

In addition, Facebook offers marketers the ability to include social context with their promotional messages. Companies that advertise on Facebook can direct viewers of their ads to specific destinations, such as their internet web sites.

When marketers create an ad campaign on Facebook, they can specify their marketing objectives and the types of people they want to reach. They can also use Facebook’s products to target specific audiences, such as people who have expressed an interest previously in the marketer’s products and services.

Businesses that use Facebook’s advertising platforms can track the results of their ads easily and modify their ad campaigns accordingly.

In an effort to expand its offerings, during August 2012 Facebook acquired Instagram, a photo-sharing service with more than 100 million registered users. On Feb. 19, the company announced that it had reached a definitive agreement to acquire WhatsApp, a rapidly growing real-time mobile messaging service with more than 450 million monthly users.

On March 14, the company announced that it had reached a definitive agreement to acquire Oculus VR, Inc., a next-generation consumer virtual reality platform that has built strong interest among developers, having received more than 75,000 orders for development kits for the company's virtual reality headset, the Oculus Rift.

Although the applications for virtual reality technology beyond gaming are in their nascent stages, several industries are already experimenting with the technology, and Facebook plans to extend Oculus' existing advantage in gaming to new product offerings, including applications for communications, media, and education.

In addition to the acquisitions mentioned above, Facebook acquired approximately $725 million of patents and other intellectual property rights over the past two years. The largest of those intangible asset purchases occurred during June 2012 when the company acquired Microsoft's rights to acquire approximately 615 U.S. patents and patent applications and certain of their foreign counterparts, consisting of approximately 170 foreign patents and patent applications, that were subject to an agreement between AOL Inc. and Microsoft entered into on April 5, 2012.

Facebook stated in its 2013 annual report that it plans to continue to make strategic acquisitions that would result in the company acquiring specialized employees and complementary companies, products, or technologies.

As a result of its targeted and growing advertising offerings, Facebook grew its revenues and earnings at very fast rates over the past few years. Specifically, the company grew its revenues by more than tenfold, and its net income by more than sixfold, from the beginning of 2010 to the end of 2013.

Meanwhile, the company is very strong financially, with its cash and marketable securities alone covering all of its financial obligations by a margin of 5.5-to-1 as of March 31, 2014.

Although Facebook’s strong financial condition enables the company to continue to acquire other social media companies and places it in a position to continue to expand its advertising offerings, my research indicates that Facebook will not be able to grow its earnings at a fast enough pace to justify the current price of the company’s stock.

For example, my research indicates that Facebook would need to grow its net earnings per share by an average rate of around 85 percent over each of the next three years to justify the closing price of its common stock on May 30.

Although Facebook’s net income rose by 28-fold during 2013, as compared to the prior year, much of that increase resulted from the company’s acquisition of Instagram. In comparison, Facebook’s net earnings grew at an average rate of only 45 percent from the beginning of 2010 to the end of 2012.

Facebook’s management team seems to agree with my analysis, saying in the company’s 2013 annual report, “We expect our rates of growth may decline in the future.” The company’s management went on to say, “While we have recently experienced increased revenue growth compared to prior periods, we expect that our user growth and revenue growth rates will decline over time as the size of our active user base increases and as we achieve greater market penetration.”

Therefore, with FB closing on Thursday at a price-to-earnings multiple of 85, I would advise investors and stock market speculators to avoid placing any of their financial market assets into the company’s stock. Near midday Friday, Facebook stock was at $63.27.

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David N. Frazier has an extensive background in the investment securities industry and has invested in the financial markets for more than 25 years.

In addition to working as a business analyst, merchant banking analyst and equity research analyst, he’s held positions in sales and marketing at institutional investment firms, including William O’Neil & Co., TDAmeritrade, and Merrill Lynch.

David now serves as the President and Chief Market Strategist of Frazier & Mayer Research, LLC (dba www.TheMarketMonk.com), an independent investment research firm that provides research and analytical services to hedge funds, investment advisory firms, and other investment newsletters.

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I'm sure you're familiar with social media powerhouse Facebook (FB), which more than a billion people around the world use on a regular basis to communicate with their family and friends, but you might not know how the company generates its revenues.
facebook, FB, stock price, investing
Friday, 30 May 2014 11:14 AM
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