Monday, 30 July 2012

Facebook - why its still expensive

The use, and abuse of valuation ratios

Investors place great store on valuation ratios - P/E being the usual suspect, EV/EBITDA if you feel like completely ignoring the capital intensity of a business (particularly widely used - bizarrely - capital intensive businesses like telcos), EV/Sales if you're a growth junkie.

The most notorious offender is of course the PEG ratio (P/E-to-growth) which I call the Great Glass Elevator of valuation ratios. It basically tells you that the elevator is going up very fast, without giving you a clue as to when its going to smash very hard into the top of the lift shaft. Therefore it only works if, like Charlie's Great Glass Elevator, there is no top of the shaft and you can simply carry on going up.

Anyhow I digress.

The important think to remember is that financial valuation ratios are useless as standalone tools to valuation. The only measure of true value of an investment is the value of its cashflows to the holder, best assessed by a discounted cashflow or its more esoteric (but neglected cousin) the EVA model. And yes I am aware both of these are hostage to your cost of capital assumption. Hey, no-one's perfect.

However where valuation ratios are useful is as a convenient shortcut to assess valuation. A back-of-fag-packet calculation. An arrow on the treasure map which points towards the treasure lies. And so long as you don't mistake the arrow for the treasure, they can actually be quite useful.

Facebook is a case in point. With the shares having crashed a cool 19% in the past week there has been a huge debate over its growth prospects. Its worth using an EV/Sales ratio to unpack what growth the market is still pricing in.

The market still thinks Facebook can do $12bn of revenues

I presented a very quick-and-dirty version of this analysis in an earlier post. What I'm doing now is updating and refining it, based on Facebook's recent falls.

A quick recap. The Price/Sales ratio (or EV/Sales as I'm using here, which nets off Facebook's $2bn cash pile) presents the value of a company as a multiple of its sales. Actually as I said before, the fundamental value of the company is tied to the amount of cash profit it generates, so the EV/Sales multiple is really a shortcut which assesses how good a company is at turning sales into profits. A higher multiple if its better at this, a lower one if its worse.

This is, of course, a stock market practitioners's perspective. Any business school professors out there shout out if you disagree.

In essence there are two factors driving an EV/Sales multiple. 1) How fast those sales will grow. 2) What proportion of those sales will be converted to profits (primarily what margin will they come out, though I acknowledge tax and earnings quality are also potential factors).

As a rule of thumb each 10% of operating margin equates to a 1x EV/Sales multiple for equities. As I said in my earlier post, an IT Services company doing a 10% margin trades on around 1x EV/Sales across the cycle, a software company doing a 25% margin around 2.5x. Trust me, it just works (if you're a stickler you can mathematically derive this - just run a Gordons' Growth Model with g = 3%, r=10% and a 30% tax rate).

So what does this mean for Facebook? Facebook currently has a market capitalisation of $50bn (or an Enterprise Value of $48bn, net of cash). If we assume a 40% long-term operating margin (about the Microsoft/Oracle/Large-Monopoly-Company-Margin) this implies a theoretical EV/Sales of 4x (note I've knocked this down from the 50% I used in my previous post, to be conservative). To justify this Facebook would need to have annual revenues of a shade over $12bn on my calculations (4x EV/Sales = $48bn EV / $12bn Sales).

That's on helluva growth hurdle

The problem is that Facebook currently has an annualised run-rate of $4.7bn of sales (+32% YoY). If it going to grow to the $12bn of sales the market is expecting it needs to sustain its current growth rate for another four more years. The chart below lays out the YoY growth rate the market is currently implying for Facebook.

The problem is, of course, as every commentator reminds you is that growth rates have been sharply declining. As I have written before there are still plenty of users (albeit in poorer parts of the world that Facebook could win. And there is a lot that they could do to raise their ARPU and boost revenues.

But the point is that, even after recent falls, the market is still pricing in that they will do that.

There is no margin of safety for the investor here.


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