Facebook – making implicit assumptions explicit
Obviously, Facebook has been in the news a lot recently. And Geoff has written a couple of articles that touch on the company directly and indirectly. Also, I’ve been reading up on the company recently and thought it would be interesting to post about whether Facebook could be a value investment.
This is basically just addressing directly some of the implicit assumptions that get made when you look at a fast growth stock like Facebook. I’m not going to go into Facebook as a business in detail. This is more about testing how realistic assumptions about Facebook’s growth really are. Now that said – I do have a view on Facebook’s business quality. In short – it’s extreme. This is a company that can convert 35 – 40% of sales into free cash flow while growing at very very fast rates. But I’m not going to break that down or look at the sustainability of the business in this post.
First, I am going to start with the premise that, economically, Facebook is a media network wholly dependent on advertising revenue. Right now, that’s true. There is a tiny amount of non advertising revenue, but it is immaterial. Of course, this may not always be true. It could find other sources of revenue. But that is completely speculative.
So we can say, one, the addressable market for Facebook is global ad spending. And two, we can assume that ad spending will grow over time with nominal GDP.
The most recent figures I can find estimate global ad spending for 2018 to be $558 billion. Obviously, you can find other estimates, but they’re not going to be hugely different, so we can work with that figure.
Let’s assume that grows at 4% per year for the next 10 years (roughly, nominal GDP – maybe this is a bit on the conservative side). 2028 ad spending would be $826 billion.
Now let’s look at Facebook. 2017 sales were $40.7 billion. Then let’s assume Facebook can grow sales at 15% per year for the next 10 years. This gives 2028 sales of $164 billion.
If Facebook grows like that, it will get further scale benefits so I am comfortable assuming a 40% free cash flow margin. That gives free cash flow of $65.9 billion.
Shares outstanding could be 3,603 million in 2028 (assuming dilution of 2% a year). So, that gives free cash flow per share of $18.29.
If you assume a 15x FCF multiple for “mature Facebook”, that gives a 2028 value of $274/share. So, roughly 65% higher over 10 years. Now, some of that is quite conservative. For example, it gives no credit for the huge cash buildup that would take place over this period (though that raises questions of capital allocation which are not easy to answer in Facebook’s case). It quite probably understates what Facebook’s margins could look like. And a 15x multiple is pretty cheap for a business of Facebook’s quality, even if it’s just a nominal GDP grower.
But more important than those assumptions is what this level of sales growth means in terms of market share.
If Facebook achieves $164 billion of revenue by 2028, it will – just on its own – be around 20% of global ad spending. ($164 million / $826 billion = 19.9%.)
Is that possible? Maybe. Facebook today has roughly 7% of the global ad market. So, under this scenario, it would roughly triple its market share.
Honestly, that level of market share doesn’t seem outlandish to me. Now, clearly, my assumptions above do not create a good return in Facebook stock. What if we take analyst consensus for Facebook’s 2018 revenue, of $55 billion, and then assume it can grow at 15% per year from then on to 2028? Well that gives:
2028 revenue: $193 billion
2028 free cash flow: $77 billion
2028 FCF/share: $21.48
2028 value: $322/share
And more importantly, 2028 share of global ad market: 34%.
I don’t know. Honestly, that’s starting to get a little more difficult to believe. If Facebook can maintain its competitive position, it doesn’t seem impossible. But you are relying on something like 70% of global ad spending being online (this doesn’t seem outlandish at all) and 50% of online spend being on Facebook (this is more questionable).
I really like Facebook as a business. I’m not sure I’ve ever come across a better business than Facebook just on the numbers. But the growth assumptions embedded both in Facebook’s share price and in its business culture make me nervous of investing when my estimates of a satisfactory growth rate end up with the company controlling 34% of the ad market, and something like 50% of the online ad market, for many years to come.
Does anyone else have a view here? Are there any obvious holes in what I’ve sketched out above?