Disclaimer & Disclosure: This article represents my views and opinions. This is not an incitement to invest. You are responsible for your own money. Neither I nor any elements of associates of Dr Wealth will be responsible for the loss of your capital. I strongly urge you to remain objective and emotionally dead whilst identifying opportunities to buy the proverbial dollar for fifty cents.
Current Trade war tensions, the oil conflicts in the Middle East, Hong Kong’s protests, as well as the uncertainty of Brexit has created a tornado of fear and uncertainty.
This is a good thing.
It is in times of crisis, bad news, and recessions when investors are best able to hunt great businesses at incredible prices. This is especially the case when the business you are investigating has been in the news recently for all the wrong reasons. Bad news damage stock prices, in turn, making the underlying business a candidate for investment when it might have been previously overpriced.
Facebook has recently been in the news as well – and for all the wrong reasons.
- A whistleblower came forward in March to reveal that Cambridge Analytica improperly harvested the personal Facebook data of 50 million people in order to profile and target users for political advertisements. After five days of silence, Mark Zuckerberg apologised for his company’s “mistakes”.
- A bug in June caused a glitch that publicly published the posts of 14 million users that were intended to be private. Erin Egan, Facebook’s chief privacy officer, apologised for the “mistake” and said the company had since fixed the glitch.
- Hackers were able to access and steal personal information in nearly half of the 30m accounts affected in a September security breach. The company initially believed that 50 million users were affected in an attack that gave the hackers control of accounts.
- Mark Zuckerberg faced accusations in a lawsuit filed by the software firm Six4Three in May that he “weaponised” the ability to access user data. The company has rejected all such claims and has repeatedly made motions to have the case dismissed.
- It was this same lawsuit that led to a cache of internal communications coming out after the UK parliament obtained the documents in an extraordinary move to hold Facebook and Zuckerberg accountable. The documents were under seal by a California court, and Facebook’s attorneys and the judge in the case have both criticised Six4Three’s legal team for turning over the confidential papers.
- These documents revealed that Facebook staff did discuss selling access to user data to advertisers in 2012 before deciding to restrict such access two years later.
- The documents also led to Facebook finally agreeing to a hearing in front of the House of Commons, which took place in November. Facebook sent a representative, the former Liberal Democrat MP Richard Allan. During hours of questioning, it was revealed that an engineer had warned the company in 2014 that users apparently based in Russia were collecting large amounts of data each day. A company spokesperson later commented that the matter was properly investigated and deemed not a data breach.
- In March, users realised that the company had collected text messages and phone call records through smartphone apps without their consent. Facebook immediately issued a “fact check” claiming “people have to expressly agree to use this feature” and “uploading this information has always been opt-in only”. But the “fact check” did not acknowledge that some previous notification screens did not warn users that call and text history would be uploaded.
- This has since led to a class-action lawsuit alleging that, in doing this, Facebook “presents several wrongs, including a consumer bait-and-switch, an invasion of privacy, wrongful monitoring of minors and potential attacks on privileged communications”. Facebook has said it asks for users’ permission to enable the feature that gives access to call logs.
- Facebook said it stopped giving third-party app developers access to user data in 2015. But the Wall Street Journal reported in June that the social network continued to share users’ data with third-party developers even after the date that executives claimed the practice would stop. Facebook officials confirmed this report.
- The source of the roundup regarding Facebook’s troubles can be found here.
Whether the above news pieces are true or not is not something that overly concerns me. What I care about is that the news is negative and that it does not destroy the business’s future potential – and as is evident later on, has not.
But the negative news has sent Facebook’s price down from USD$204.66 to its current USD $189.02. Moreover, Mark Zuckerberg, together with his Chief Financial Officer David Wehner has put out official warnings about how they would have to devote business dollars towards implementing checks and balances….against themselves. You can access Mark Zuckerberg’s Facebook post about that here.
All of these leaves an important question: Is Facebook undervalued? And if so, by how much?
Figuring out how much it’s worth in the future will let us know our likely returns since how much we are paying now is a known quantity (as at time of writing, Facebook is trading at 33 times price to earnings, at USD$194.21, I kick myself often for not having bought in during the $140 period while having rather firmly grasped the fundamentals of the business which is fueling this article today).
Let’s talk specifics.
#1 How Does Facebook Make Money?
Facebook derives profits in three main stages.
- Gather Users.
- Gather Data.
- Monetise Consumer Database
A) Gather Users
Facebook, in all probability, will continue to build, develop, and improve its social applications Facebook, Instagram, and Whatsapp, which in total have 2.7 billion users.
Design professionals will be familiar with concepts such as “Hook” and “Stickiness” as well as “Integration”. The basis of such design concepts is that the application is designed from the ground up to be something people won’t want to do without. Facebook does this enabling a “sense of connection” between you and your friends, family, and colleagues.
Once the user is hooked towards staying “connected”, users are encouraged to stay connected, typically via a reward system of likes, shares, comments, and other “responses” available to your post. This is on top of the fact that people can use facebook a variety of ways, including but not limited to:
- Job offerings
- Services offerings
- Selling items
- Buying items
- News updates around the world and in the country
- Most governmental agencies around the world, including Singapore, has a Facebook account.
B) Gather Data
As more and more people use Facebook, engaging through likes, dislikes, angry emojis, sharing of content via google, and publishing original content, Facebook gathers more data.
Its algorithm is constantly being refined to see and adapt to what the user likes, wants to use, wants to engage with, and wants to see more of.
This is rather significant if you deliberate on it.
Facebook has effectively turned you into a product that improves itself.
You help them generate revenue, target you better with advertisements, and by telling them what you like/dislike.
How many businesses can claim to have that kind of power over its consumers/revenue generators?
There are few if any businesses capable of doing this other than Facebook itself. The only one that comes to mind thus far is WeChat, owned and operated by Tencent, a stock that my colleague Khinwai is currently vested in.
C) Monetise Consumer Database
Facebook, as of June 2019, has 2.41 billion monthly active users.
What do you do once you have a huge platform of people constantly curating their feeds for you?
You monetise the huge amount of attention, eyeballs, and exposure a business can attract by advertising to those people. Facebook’s algorithm further refines this by presenting only the most relevant ads to its consumers.
In other words, whether by design or by chance, Facebook has managed to find a way for all three parties in the consumer chain to win.
You must understand that because Facebook is able to create such win-win scenarios, it will be able to repeatedly draw in more users, more business, more data, and continue the everlasting virtuous cycle of growth.
Facebook is also a prime example of what we call the “Positive Network Effect”, one of the most powerful durable competitive advantages a business can have.
Why is Facebook A Good Business? Positive Network Effect
A Positive Network Effect is basically when more usage of the product by a user increases the product’s value for other users (and sometimes all users).
The more you use a product, the greater the product becomes. This is the same for all users. The more users there are, the better the product becomes. If it sounds invincible and all-powerful, that’s because it is.
There are few failure states for a network effect business model once it has gained sufficient scale and mass outside of total network collapse.
- Facebook becomes more valuable when more people use Facebook (more social connections, more job listings, more services, more offers, more advertising dollars, more relevant ads, this goes double for Facebook Dating, imagine trying to have just 5 people on a dating app!).
- Whatsapp becomes more valuable when more people use Whatsapp. (It quickly becomes a hassle to contact other ppl. Shifting from telegram to WhatsApp might be relatively easy, but why introduce friction at all when we can all use one similar app?)
- Instagram becomes more valuable when more people use Instagram. (Again, having 10 people alone on Instagram would not make the app anything useful.)
In case you’re still wondering why Facebook bought Whatsapp and Instagram, you can stop wondering why.
Buying companies, however, cost a lot of money. Whatsapp cost Facebook a whopping $19 billion. Instagram had no revenue and yet cost Facebook $1 billion to acquire. All the business strengths/competitive advantages in the world won’t matter if the company is a badly run financial mess like Hyflux was.
So how is Facebook’s financial position?
#2 What Is Facebook’s Current Financial Health?
Some quick numbers to help us understand exactly how strong Facebook is:
- Facebook’s interest coverage ratio is 21.12, signifying strong ability to pay any interest on outstanding debt. As a rule of thumb, we want it above 5. Facebook passes this test with flying colours.
- Facebook’s Altman Z score is currently 13.94. An Altman Z Score of 3 and above indicates good financial health. Again, Facebook passes this test with flying colours.
- Facebook’s 5-year average free cash flow is positive and growing, though there is a slight decline in 2018. Looking forward, further declines might be possible given that the company will have to spend more of its earning to appease regulatory oversight.
- Facebook’s cash hoard in 2019 as of recent declarations is $48.596 billion. And FB’s total liabilities as of recent earnings disclosures are $28.244 billion. Of note, total liabilities climbed 158.91% while total cash hoard grew only 14.86%.
- Facebook’s operating expenses and capital expenditures also grew as illustrated below.
Overall, the company is rather robust and insulated against financial problems. Obviously, this assumption only holds true as long as Facebook’s management does not attempt financially questionable manoeuvres as Hyflux did.
In the short run, I expect regulatory oversight from American authorities to eat into profit margins while American re-elections contribute a cushion towards Facebook’s reported profit. In 2018, roughly 20% of all political advertisement spending was on social media platforms like Facebook and Google. An estimated $10 billion will be spent in this coming elections, double that of 2016-2018’s election run. By those estimates, Facebook’s earnings will likely see a short term boost of close to 3%.
Is this enough to offset rising capital expenditure costs and operating expenses plus the necessary expenditures to ‘regulate themselves? Only time will tell.
What I feel confident about is that provided no major upsets happen, Facebook remains financially robust and capable of operations.
#3 Facebook: How Much Room Does It Have To Grow?
In all investing outcomes, the prospective investor looks to buy the proverbial dollar for less than a dollar. Someone once said that when you buy a share, it’s either worth more than what you paid for it or its not. That’s a marvellous saying that has never left my head since in the arena of investing.
The question at hand then, is how much of a runway does Facebook have left to grow?
Facebook’s growth runway will determine its future value. And the difference between what I pay now and what I pay in the future will be my returns. Naturally, we need to take an educated guess at the company’s future.
Facebook currently derives almost 92% of its revenues via advertising. Let’s take a look.
Based on current numbers, Facebook possesses a mere 10% of global ad spending.
Note that some experts regard total ad spending to actually be closer to a trillion dollars thanks to some amount of advertising space right now that are not considered digital such as billboard, etc Cetera.
In an increasingly digital age, where digital advertisements outpace their old school counterparts in terms of return on investments, more and more advertising dollars will flow towards digital ad spending, which means that not only is Facebook holding only a small piece of the pie, it’s holding a small piece of a growing pie.
More, Facebook’s user base has not really slowed in growing. Neither has their daily active user base or their revenue.
Note that the numbers above, near as I can tell are not inclusive of Instagram’s numbers or growth, all of this are purely based on Facebook’s platform, which is rather insane.
Facebook’s Average Revenue Per User has also grown even as its pool of users grew dramatically.
Facebook’s current market share compared to the world’s global advertisement spending is barely a drop in the bucket at 5%. Looking forward, as the world speeds up digitalisation and mobile usage, I expect Facebook to gain significant market share in the trillion-dollar industry due to its ability to deliver higher returns on advertising dollars.
Note that thus far, I have not even covered the monetisation capabilities of Whatsapp, Instagram and Facebook Dating.
- Whatsapp pay is now being rolled out in India, which is the leader in terms of Facebook users worldwide and if rolled out worldwide, will probably see Facebook gain access to a new source of income (Visa, Mastercard)
- Instagram now allows users to purchase items directly off of the app, much like Shopify and Amazon.
- Oculus VR will allow Facebook to enter the games segment.
So is there potential for the company to grow much larger? Going by both quantitative and qualitative factors, yes. It’s social
In the short term, I do expect prices to be driven down slightly, but not by too much (for you timing folks out there). Facebook has a ton of room to grow and the resources to do it.
What Facebook needs is time to mature and the proper guidance to steer it, of which Mark Zuckerberg and Sheryl Sandberg have proven capable of based on their decisions thus far.
They switched into the mobile-first platform early, they bought WhatsApp and Instagram, tried to buy Snapchat, allowed photos and not just text, and the management has basically defined foresight in its short run.
I foresee only selling Facebook if and only if there is a real and sustainable risk to Facebook’s ability to attract new users and maintain active users since Facebook’s user base serves as the company’s gateway to 1) advertisement revenue, 2) content creation, and 3) wide moat via network effect, all at the same time – the monetisation abilities of Whatsapp, Instagram, and OculusVR notwithstanding.
Overall, a doomsday scenario happening to Facebook is unlikely given Facebook’s stickiness, usability, and everyday life integration, although changing political and corporate climates can make anything happen and I am always leery of making predictions.
Short of such a doomsday scenario, I remain long on Facebook and it’s ability to generate superior returns as long as;
- Current management Mark Zuckerberg and Sheryl Sandberg continue to remain long term oriented as evidenced in their business activity (attempt to purchase Snapchat, purchase of Whatsapp, purchase of Instagram, Libra, Oculus VR) and,
- There remains no credible threat to Facebook acquiring or engaging new users, or its current user base, or increasing engagements to its current user base.
- Facebook remains the most optimal digital platform in terms of return on investment for businesses big or small to spend advertising dollars on.
I have attempted in this case to present a wide spectrum top-down look at Facebook as a business.
Ultimately, in the decades to come, should Facebook manoeuvre correctly, I believe it could be a $300 – $1,000 stock. Is its current price of $189 fair then? It is for me. I’m virtually paying cents on the dollar by buying in right now.
Each time before I invest, I try to war game scenarios where a business can be shut down or left virtually dead. The point of such an exercise is obvious – to see possibilities of lethality to my investment capital.
With that in mind, I have come up with various possibilities where I face maximum losses. Here are the possible scenarios:
- regulatory oversight –> Facebook has repeatedly mentioned that it is putting into place measures to safeguard user privacy and data. There stands a risk where a law is introduced to prevent Facebook from allowing user data to be utilised in advertisement targetting, in which case the dollar cost returns of advertising budgets for business big or small will see a massive drop. Should the returns drop, businesses will stop spending as much and Facebook’s revenue will accordingly drop.
- total network collapse –> Again. Such a possibility is real but not predictable. A network is at all times vulnerable to assault and it is only as safe as its engineering team/developer team’s protective measures.
Is there any way to prevent this from affecting my investment? Yes.
Options can act as an insurance policy should I choose to utilise them (and I likely will), although obviously, I will have to watch the premium I’m paying as it might eat into my returns. Remaining debit positive will be difficult, but should the unthinkable happen, I will be much happier to be able to not just protect my investment but benefit from Facebook’s plunge in share prices.
I hope this has been informative.
Behavioural Psychology fanatic. I like good food, movies, intelligent conversations and logical reasoning. I also dabble with options, factor-based investing, and data analytics.