Monday, July 30, 2018

Facebook Still Blows My Mind

But I think there is systemic prejudice against it


Do you remember how Facebook's shares performed when they first went public?  They dropped.  They lost more than half their value in six months.



It was an illogical situation.  Did another one happen again?

Why I'm long


In June 2017 I wrote an article for Seeking Alpha on a powerful valuation method called the Ohlson Clean Surplus (OCS) and as part of it, I ran a valuation on Facebook.  I wasn't long the stock, hadn't looked at it before and I also knew it would present challenges for the model and part of my article was how to deal with challenges.  I had no expectations.

The OCS needed to be modified to allow for the company's growth but it was so high that it just rattled the model.  I had to use pared back growth rates just to keep it from being ridiculous.

I also noticed that although the stock price was growing rapidly, it by no means was keeping pace with earnings CAGR.

The growth rate wasn't the only factor.  The model uses book value per share but a company like Facebook is going to have so much off-balance sheet assets that the number will be wildly inaccurate.

Intrigued, I ran Facebook through another model I have that measures quality of earnings.  Briefly, the quality of earnings measure cuts through manipulations that a company can use to improve their bottom line.  There are eight or nine sub-scores that are added together to get a final score, the higher the better.  It's very useful.  It was high, almost a perfect score.

This stock looked incredible to me and I rolled some of its other features around in my head.  It's got something close to a third of the planet using it or one of its child applications (by child I mean from a corporate structure standpoint, Facebook is the parent, WhatsApp, Instagram etc are children).  It has no peers, it is a monopoly and its moat is not only broad and deep, its infested with radio-active alligators that can bit through a ship's hull and jump out of the water to catch bombs lobbed at the castle.

Remember in the movie, The Social Network, when the Sean Parker character says "You don't even know what this thing is yet," I had the feeling that was still the case, but the "you" was the market.  I felt that I was looking at the world's next most valuable company.

But after Thursday, I wondered if there is some basic dislike of the company, some schadenfreude going on.  It is remarkable in more than one way.  The founder was incredibly young when he experienced mind-boggling, jealousy-inducing success.  The Social Network portrayed the MZ character in an unflattering light.

But that's speculation.  I love facts (especially analytical facts) and I have a quivering respect for the omniscience of the market.

So, should I still be long?  Should you be?  A cardinal rule: don't fall in love with the stocks you pick.  Be objective ALL THE TIME.

So let's look at this, objectively.

Let's get through the easy stuff first:

1) Quality of earnings. 


I ran this model with nine factors against the M-FAANG portfolio to give the number some context relative to "peers".   (M stands for Microsoft; just because FAANG makes a nifty acronym doesn't make it right.  As far as I'm concerned a company that produces software used by almost everyone qualifies as a unique, dominant and formidable company.)  Here's the results:

That's eight out of nine.  What did it fail to get a score in?  Inventories.  FB doesn't have inventory (neither does Netflix).  If you extract it, you get a perfect earnings score of eight out of eight.  How often does this happen? It's the first time I've seen it.

2) Earnings Growth


I think for a growth company it is good to see earnings growing.  Let's see how well FB has grown its year over year earnings.  I'll compare it to the M-FAANG portfolio.


The maximum score is six.  FB didn't have earnings growth in the first year over year growth period, Y-6 to Y-5.

3) Valuation

This is where it gets tricky.

Running a straight up OCS valuation with no changes to the underlying assumption results in a theoretical stock price of $56.  I know that isn't accurate, no one familiar with the model would consider that a correct valuation.  We have to tweak some of the assumptions.

I'm going to look at two assumptions, the starting book value and I'm going to include a growth rate for the return on equity.  I'm going to leave the dividend payout ratio at zero and I'm assuming a stock market growth rate of 7%.

If I use a growth factor on the ROE of 15% I get a price equal to the current share price, $176.
If I increase the book value per share by 2.7 and remove the growth factor entirely I get a price equal to the current share price.
If I double the book value and use a growth factor of 5% I get a price close to the current share price.

How do I feel about the assumption changes?

I feel uncomfortable making a growth call.  David Wehner the CFO advised their growth rates are coming down.  I've spent some time fiddling with the growth numbers and I don't have anything conclusive.

I'm also not comfortable making a statement on what the book value should be.

I will say there is a growth rate, but I don't know what it is at the moment.

I will say there are a tonne of off-balance sheet assets but I won't begin to try to value it.

(Audience base - what's the value of 2 billion people addicted to your platform?
IP - how does one begin to value over 10,000 patents?  Or cutting edge development into AI?
Cultural - When what you do enters into the lexicon and changes the nuance of certain basic words such as "like" and "friend" how does one put a dollar value on that?)

I will say I'm more than comfortable with the modest assumption changes of doubling the book value and a growth rate of 5%.

How do you feel about it?

Existential Risk


Facebook made some blunders with its data and by not caring who paid for advertising.  If management didn't take them seriously, these mistakes would have marked the eventual end of the comapny.  But management did.

That's why their expenses are up, they're investing in mortar to strengthen their citadel.

That's why their revenue growth is down, they're  cutting out dodgy sources and why it will continue to decelerate for a period of time.  The short term perspective says panic.  The long-term view says these changes insure the company's future.

In my opinion, this is evidence of management's long-term vision and it's wise and it's bullish.

Still long


Facebook is a buy and I might pick up some more.

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