The most optimistic 2022 earnings per share expectation for Facebook is $4.50. If the stock trades at 20x earnings, the per share value of the social media giant would be $90. If it trades at 25x earnings, the valuation would be $112.50. With the price of Facebook stock now sitting at $114 per share, the business performance of Facebook the company will have to exceed the expectations of the most optimistic Wall Street analyst or the long-term valuation of Facebook stock will have to be north of 25x earnings–one of those must come true for you to earn a positive return on Facebook stock over the next eight years.
I do not share that optimistic view of Facebook’s future earnings growth because the optimistic projections act as if United States will never enter a recession any time in the next few years which is important because advertisement rates are highly cyclical. I think what is happening is that analysts are looking at Facebook’s ad revenue growth since its 2012 IPO, and then taking user count growth to make assumptions that it can be sustained indefinitely and monetized at a similar rate to Facebook’s ad revenue growth from 2012-2015.
The problem is that, when recessions hit, many mid-tier companies stop advertising altogether and large-cap companies become more selective about their advertising and insist on much lower rates. It’s as if nothing is learned from studying old records at the New York Times that showed the 68% reduction in ad revenue that occurred from the end of 1972 until the worst of the 1974 recession. Online advertising can be even more volatile, depending on the site. Facebook would fare better than most, though I suspect advertising revenue could still fall over 50% during a 2008-2009 type of environment.
Under realistically optimistic projections, I would expect Facebook to make around $3.50 per share in 2022. That’s still quite generous, considering that Facebook has only made $1.29 over the past twelve months. If it reaches that height, I would expect the valuation of the stock to be somewhere around 25x earnings (though this is entirely guesswork as double-digit earnings growth can maintain P/E ratios well north of 20x earnings while single-digit earnings growth can whipsaw the P/E ratios into the teens. This is why growth investing with richly valued stocks can be dangerous–if the growth falters, the P/E ratio also plummets to produce a double whammy effect on your future returns).
That would give Facebook a share price of $90 per share in 2022. People that buy the stock today would lose about $24 per share over the next eight years, for a 21% net loss over the longish medium-term.
When I study something like Facebook, I am reminded of Peter Lynch’s caveat to investors about his advice to “buy what you know.” He argued that people needed to pay attention to the relationship between the price of the stock and the earnings that it represents, otherwise people will do things like buy Ford at the top of the auto business cycle because everyone has heard of Ford and it seems like the car industry is doing well.
Facebook belongs in a close category of that. Everybody knows of its monopolizing power in social media. Not only does it benefit from the escalating emotional investment of its users that acquire friends and build prestige/reputational capital through their postings, but it is also become a significant news source as people are increasingly using it as the original source material to get a quick peek at the day’s headlines.
But that is hard to convert into future growth. There are already 1.5 billion active Facebook users. The advertisement rates seem high. It is beginning to facilitate credit card payments, and if Facebook is used as a center of monetary change–will babysitters of the future get into their bank account through a Facebook message blip of $20–then there is a possibility that it could radically grow its profits quickly.
But it’s already the sixth largest company in the world. It’s basically the same size as Berkshire Hathaway on valuation–Berkshire Hathaway is around $350 billion, Facebook is around $330. But Facebook makes about $4 billion in profits, and Berkshire Hathaway makes $24 billion in net profits. You get 6x the current profits from Berkshire Hathaway that you get from Facebook. Even if Facebook has a much higher earnings per share growth rate, that is an extreme difference in starting valuation of profits that will be difficult to make up.
A bet on Facebook is really a bet against stock market history. I can think of no other instances where extremely valued mega-caps ended up producing superior returns over the long-run. The $1.29 in earnings compared to the $114 share price is an 88x earnings valuation–the kind of thing that you would tolerate from a startup that seems to have an avenue to extraordinary earnings growth. But Facebook is no start up–it’s valued at $330 billion right now. That is an extreme way to value $4 billion in profits.
The financial “story” behind Facebook is great. It has $18 billion in cash. It has 52% top-line growth over the past year. If you have owned it, it’s probably been one of the best performers in your portfolio. Even otherwise sober analysts end up recommending the shares, though it seems to me that people are lowering their traditional investment standards due to a combination of recency bias and a sense of that’s what everybody else is doing.
It makes me want to go back and dig up some of the first-person accounts I read from investors that switched to internet-heavy portfolios in the late 1990s and saw a few hundred thousand dollars grow into millions of dollars before turning into decimation of retirement portfolios. I might go ahead and look for them, since it might help some people remember what happens when good stories create momentum stocks that have valuations disconnected from reality.
Facebook isn’t quite the same as the typical 1990s tech stock, as it does have a strong market position and real honest-to-God profits of $4 billion. But the issue is that those $4 billion profits, and the expected future growth of them, is divorced from the $330 billion valuation of the corporation. All long-term P/E ratios tend to eventually revert to the 20x earnings range as mega-caps reach that inevitable point where they can’t grow much faster than 8-12% over the subsequent long term. That implies Facebook has to decrease its P/E ratio four-fold over the long haul, and that will impose an extraordinary strong gravitational pull that will weigh down the future returns of the stock.
The best case scenario for Facebook stock investors over the next eight years is that they don’t lose much money, and the so-so scenarios will result in significant capital impairments. Someone who pays 30x earnings for Nike and Google are far more rational than those paying hundreds of times earnings for Amazon and nearly 90x earnings for Facebook. A best case scenario for the first two would still beat the market; the best case scenario for the latter two would avoid capital losses. If you assume that a connection between cash flows and the valuation of the business at some point becomes a relevant determination of business value, then run the numbers of necessary growth projections that would be necessary to make a Facebook or Amazon investment work. It can’t be done.
Originally posted 2016-03-31 00:11:07.