Facebook - Optimism Not Based On Fundamentals

Yesterday Facebook announced its 2015 preliminary results. It is not an easy task to analyze this company - simply put, it has a very short financial history. What is more, Facebook's strength is based on its popularity among its users - the company is something like a fashion company.

However, let me try to do it in a simple, as usual, way.

I assume that the company's valuation is driven by its ability to deliver positive cash flows. Facebook was definitely able to deliver higher and higher cash flows from operations:

Of course, in the case of Facebook, its ability to deliver cash flow from operations is strictly linked to the company's revenue. In other words, the higher revenue the higher cash flow from operations.

At this point I see the first scratch. Facebook is still able to increase its revenue from year to year but last year this growth was weaker:

Well, I guess that the company is going to face this phenomenon in the coming future - it is really hard to increase such a high revenue ($17.9 billion in 2015) through organic growth.

That is why Facebook should focus on improving its effectiveness, for example through increasing its cash flow margin. To remind my readers, cash flow margin says what amount of cash is generated by one dollar in a company's sales. In the case of Facebook, in 2015 each dollar in sales was delivering $0.44 in cash flow.

Here is another scratch. It seems that Facebook's efficiency is slowly going down:

As the chart shows, 2015 was the first year when the company's cash margin was lower than in the previous year. Putting it differently, Facebook is currently facing some limits. Its revenue is growing at a slower rate; what is more - this revenue is delivering less cash, measured on a percentage basis.

Now I can try to present a quick valuation of the company's shares. According to the company, in 2015 Facebook delivered free cash flow of $6,076 million. Let me assume that Facebook is going to grow its earnings at the rate of 3% per year, indefinitely.

Next, assuming that:

• the company's beta is 1.04
• risk free rate is 2.38%
• historical return of the stock market in the U.S. is 5.81%

then the cost of equity is 2.38% + 1.04 x (5.81% - 2.38%) = 5.95%

Facebook is a debt-free company therefore the cost of capital is equal to the cost of equity.

To find the company's business value I have to discount the annual free cash flow by the cost of capital diminished by the growth rate:

Facebook's business value = $6,076 million /  (5.95% - 3.0) = $205,966 million

To find value of equity I have to increase business' value by adding cash held by the company ($18,434 million at the end of 2015). As a result, the company's equity value is $224.4 billion.

Well, today the company's market cap (assuming that shares are trading at around $110 a piece) is around $312 billion so the company is actually overvalued by 28%.