“He was not swayed by what other people were doing or how the world was feeling that day or anything of the sort.” Isn’t that a great quote? It is what Warren Buffett said on June 25, 2011 when he was describing his mentor Benjamin Graham. Although there are limitations to the Graham strategy of investing, the greatest advantage of demanding earnings upfront at the time you make an investment is that you can receive satisfactory returns even if the business never grows as fast as you initially thought.
One of Wall Street’s current darlings is social media giant Facebook.
Right now, Facebook trades at $93.24 per share. If the stock rises a bit more to $95.20, it will be trading at 100x earnings. The value of the company is closing in on $270 billion. That is crazy–it is closing in on ExxonMobil, which makes over $35 billion per year when oil is at $85 per barrel. Facebook, meanwhile, doesn’t even make $3 billion per year yet.
Companies like Exxon do trade at 10x earnings in normal environments, and it is true that a company like Facebook would have a terminal valuation somewhere around 20x earnings. This means that Facebook would only have to hit $17.5 billion in annual profits to be on equal footing to something like Exxon. But that still calls for a six-fold increase in profits.
When Facebook makes it case to investors, it mentions that only one out of five people in the world have a Facebook account. The implication is that huge user growth lies ahead. That might be a bit misleading.
From a shareholder’s perspective, not all users are equal. Facebook makes its money off of advertising dollars, and advertising dollars flow towards the most economically prosperous countries. Facebook doesn’t disclose its ad rates by country, but I can give you an example from my site: the average American reader generates almost a 10,000% higher rate than a reader from Sudan. If all my readers were from Sudan, the revenue wouldn’t even be enough to cover the domain registration fees. And it is because Citigroup, Bank of America, and JPMorgan don’t have to spend nearly as much when they want to reach a Sudanese audience.
To study the real user base growth that will have a strong bearing on profitability, I recommend focusing on Facebook’s user activity in industrialized nations. There, the average country has a 71% participation rate on Facebook. To me, that suggests much more limited room for user growth. The ceiling is probably somewhere around 80%. Other than that, Facebook will have to rely on future growth to increase users.
As a consequence, Facebook will be unlikely to drive future growth through new users signing up for accounts. It will need to charge higher rates, which it may be able to do through the development of better ad tracking/targeting technologies. But still, that is the kind of thing that might boost profits 20% to 30%, but won’t give you a six fold increase to get to where Facebook could be fairly called a $270 billion company.
The remaining alternative is to increase the amount of ads (technically, there are other alternatives that would involve changing the business model, such as charging people a dollar per month to have a Facebook account.) Every addition of an advertisement will have a negative impact on user satisfaction. Facebook, which owns Instagram, has already received howls of pushback just for putting two advertisements on the initial screen of Instagram photos. I’m unconvinced there is room to fit 7 advertisements in there.
You can do things like pay 100x earnings for a stock when you have a high certainty that profits will grow at 30%+ for ten years straight. A company like Starbucks, which only traded at 50x earnings during its IPO, would have still compounded at over 20% annually if it was valued at 100x earnings during the time of its IPO. That is because investors got to ride the wave from $75 million in stock market capitalization to $90 billion in stock market capitalization. The P/E compression didn’t impair you.
But Facebook at $270 billion doesn’t give you that luxury. What’s a reasonable expectation for a growth investment, a double in value over the course of five years? Since Facebook doesn’t pay a dividend, it would have to be valued at $540 billion in 2020. If it traded at 20x earnings then, it would have to grow current profits of nearly $3 billion to $27 billion.
It can do that through more users, higher ad rates, more ads per page, or changes to the business model beyond the current ad-based model. The industrialized countries seem nearly saturated, and the ad rates from industrializing countries are so much lower that even sharp user growth won’t mean much to the bottom line. The possibility of higher ad rates is there, but is quite limited. That means Facebook needs to shove more ads onto the page, or tweak its business model to find new profit streams. If users were willing to accept a bunch of more ads on Facebook, they’d probably be there already. And if Facebook tries to charge users, most likely a free alternative would arrive to steal market share.
The path to riches is not paved with making investments in companies worth hundreds of billions of dollars trading very close to 100x earnings. Some of the best performing mutual funds in the past three years have been stuffed with Facebook, Tesla, and Amazon stock, and I cringe for the 401(k) investors that are going to pour their money into these funds based on attractive past history. Double-digit profit growth likely lies in the years ahead for Facebook, but it will not be nearly enough to compensate for the P/E fall from 100x earnings to the 20x earnings range.
People stacking up capital gains with Facebook stock are not building permanent value; if they stick with Facebook for the long haul, much of the paper wealth created will eventually be proved illusory. You can avoid all of this by taking the Graham approach, modifying the Tom Cruise line to “Show me the earnings!” If Bart Simpson became a guest on the old Louis Rukeyser show, he would be ordered to write on the board: I will not pay 100x earnings for a billion-dollar tech stock. I will not pay 100x earnings for a billion-dollar tech stock. I will not pay 100x earnings for a billion-dollar tech stock.