As the world's third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.
We can't know for sure whether Buffett is about to buy Facebook (Nasdaq: FB ) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us. In this series, we do just that.
Buffett's famous for his contrarianism – be fearful when others are greedy, and greedy when others are fearful. But writing in a recent 10-K, Buffett lays out the other qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:
- Consistent earnings power.
- Good returns on equity with limited or no debt.
- Management in place.
- Simple, non-techno-mumbo-jumbo businesses.
Does Facebook meet Buffett's standards?
1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.
Let's examine Facebook's earnings and free cash flow history:
Source: S&P Capital IQ.
Facebook's earnings have increased dramatically. Free cash has generally risen but fluctuated a bit over the past couple of years, mostly because of major capital expenditures.
2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it is.
Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.
Return on Equity
5-Year Average Return on Equity
|LinkedIn (Nasdaq: LNKD )||0%||4%||3%|
|Google (Nasdaq: GOOG )||12%||20%||19%|
|Groupon (Nasdaq: GPRN )||0%||(52%)||(1,175%)|
Source: S&P Capital IQ.
Despite all the attention that Facebook gets, some investors actually prefer LinkedIn. It's not yet as profitable as its larger social cousin, but the career-networking social-media platform is growing as quickly and has an enormous market opportunity in the lucrative talent-recruitment space.
Even after posting a stronger-than-expected quarter, Groupon is still struggling to find profitability. It's growing revenue quickly and its margins are getting closer to breakeven, but with high marketing costs, it remains to be seen just how scalable the coupon business really is.
Facebook earns a monster return on equity that tops even Google's. The cost of massive data centers are what's holding Google's return on equity to a very respectable 20% over several years. It remains to be seen where Facebook's will trend to as it ramps up its capital spending. But both Google and Facebook meet Buffett's high-moat, high-profitability, low-debt criterion.
There's a lot that could be said about Facebook's management, but in terms of Mark Zuckerberg's tenure -- he began writing Facebook code in 2004 and became CEO later that year, when the company incorporated.
Social media is still a new business, and questions remain about how much money it can earn and the sustainability of its moats. Despite the buzz around social-media advertising, Facebook doesn't actually earn a whole lot in ad revenue per user. And, Buffett would observe, while Facebook appears to be dominant today, social-media users have a history of fickleness -- witness the implosions of Friendster and News Corp.'s (NYSE: NWS ) MySpace.
The Foolish conclusion
So is Facebook a Buffett stock? Probably not. Although the company does have consistent or growing earnings, high returns on equity with limited debt, and tenured management, there are other issues that would keep Buffett away. Aside from concerns he would have about the company's monster valuation, at 75 times earnings, Buffett wouldn't think he has the ability to judge whether Facebook will still be around and still be dominant in 20 years. To stay up to speed on Facebook's progress, simply add it to your stock Watchlist. If you don't have one yet, you can create a Watchlist of your favorite stocks.
If you're interested in investing in a social media company, our analysts have created a new special report, "Forget Facebook -- Here's the Tech IPO You Should Be Buying," which details a stock they believe has a longer runway for growth than Facebook. The report won't be available forever, so get access today -- it's totally free.