Facebook in a Perfect World

24 July 2014

Using Google as a comp for future growth and valuation.

Last Thursday, Jim Cramer compared Facebook (FB) to Merck (MRK). According to this Seeking Alpha report,

Cramer compared Facebook to the early days of Merck, when many were skeptical about the value of the big pharma company. Some declared Merck “the most overvalued stock on Earth,” because its valuation surpassed that of General Motors (GM). Cramer had to face angry clients when his hedge fund held Merck, but his call ended up being a winner; Merck’s products ended up becoming the biggest blockbuster drugs of all-time.

(…)

Facebook has real earnings. Cramer thinks FB could earn $3 per share for 2016, and it has 60% growth. This means it should trade at $90, a 30% premium to where it is currently trading. CEO Mark Zuckerberg outlined a multi-year growth strategy. Cramer thinks it is “preposterous” that FB is that cheap. A couple of years ago, FB had no mobile strategy, and now it is the “king of mobile.” User-generated content is good for gross margins and for advertisers. Facebook may be one of the most lucrative stocks of the era.

Generally, the business model and operations of Facebook have little in common with those of Merck. But even if Merck and Facebook were similar in some ways, it would still be possible for Cramer to be right about Merck back then and less right about Facebook today. As to Facebook’s valuation, a stock price of $75 may be cheap when we look back years from now, but only if the intervening years deliver on today’s more bullish forecasts. A long-term promise is not as good as a near-term projection. And on this and next year’s metrics, the stock certainly looks richly valued.

I mention Cramer to make a point about the way investors influence each other’s decisions. I wrote recently that, because investors and traders influence each other, for example through shows like Cramer’s Mad Money or articles on Seeking Alpha or other platforms, large cap stocks like Facebook and Apple (AAPL) could at times be mispriced by very wide margins of 20%, 30% or even 50%+. We certainly saw how this could be the case in the bubble of 1999-2000 and again in 2006-07. And we are now again in a similar ‘influence’ game which further pushes up market favorites, against a very helpful backdrop of near-zero interest rates.

Instead of Merck, the company that is probably a good comp to Facebook today is Google (GOOG). Not a perfect comp, but close enough. So here is a comparison of their evolution.

Facebook’s market cap is now very close to $200 billion. Its projected sales for 2014 are around $12 billion, which means that its stock is trading at over 16x forward sales. To many, this valuation seems justified by Facebook’s very high margins and growth rates.

Google’s market cap reached $200 billion for the first time in 2007. Back then, its revenue growth rate was similar to that of Facebook today (not far from 60%) and its margins were slightly lower. Google stock in that year traded in a range of 8 to 14x sales, significantly lower than Facebook today.

Judging by what happened in subsequent years, you could say that Google’s 2007 peak valuation was justified. Since then, Google’s market cap has doubled to exceed $400 billion today. So if you are a Facebook bull, you can pencil in $400 billion as a target market cap and $150 target stock price.

The main problem with this logic is that things rarely evolve in a linear fashion. In other words, on the road to $400 billion and $150, we may first see $100 billion and $38.

An investor who bought Google stock in late 2007 and who held until today has outperformed the S&P 500 by a wide margin. But all of this outperformance has occurred in the 18 months from July 2012 to December 2013. In 2008, Google stock crashed like everything else, falling by two thirds, and its stock did not regain its 2007 high until late 2012.

Nonetheless, despite the 2008-09 crisis, Google sales continued to grow, albeit at a lower rate. Revenue growth was 56%, 31%, and 9% in 2007, 2008 and 2009. It reaccelerated in the subsequent years 2010-2013, to 24%, 29%, 32% and 19%.

Screen Shot 2015-04-22 at 4.15.25 PM

(Tables show 2014 year to date.)

As shown in the table, these are attractive growth rates but a far cry from what they were in the years to 2007. Even if you ignore the 2008-09 collapse, sales growth at Google has been on a long-term downward trend. It is very difficult if not impossible for a large company to maintain 50% growth rates.

Screen Shot 2015-04-22 at 4.15.25 PM

Going back to Facebook, there are no doubt multiple justifications to hold the stock: the increased role of mobile, the potential for higher revenues per user, the integration of acquisitions etc. But a long position is betting on both flawless execution and a supportive macro environment.

At current valuations, the stock is priced for perfection not only at the micro level (its own operations) but also on the macro level (the overall economy and market). The odds are we will not see a major crisis like 2008 again soon, but what happens to Facebook stock if the economy slows down? Advertising is a notoriously cyclical business. What if Facebook’s own growth rate slows from 60% to a still strong 30%, as happened at Google? From a level of 16x sales, Facebook’s stock would certainly fall by 20%, 40% or more, depending on the severity of the slowdown.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Facebook stock or any other security. The reader is responsible for any loss he may incur in such trading.

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