2 Reasons Facebook Will Outperform Twitter in 2014

Twitter lacks Facebook's broad appeal, and its shares are mightily expensive.

Jan 6, 2014 at 7:00PM

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Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Following a losing week, stocks were unable to reverse the trend on Monday -- even as the Senate prepares to confirm Janet Yellen as the next chair of the Federal Reserve. The S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES:^DJI) both fell 0.3%.

The stocks of Facebook (NASDAQ:FB) and Twitter (NYSE:TWTR) both turned in terrific performances in 2013. Facebook managed to shed the stigma of its shambolic 2012 May IPO and investor concerns that the transition to mobile would hurt its advertising franchise, for a doubling in its share price. Twitter, meanwhile, flew out of the gates following its November stock market launch and soared even higher, racking up a 165% return relative to its $26 offering price.

However, there are at least two reasons to believe that today, which saw Facebook's stock gain 5%, while Twitter's was down 4%, will be more representative than last year of the relative performance of the two stocks over the course of 2013. Those reasons? Appeal and valuation (but mainly valuation).

First things first: Why the divergence between the two stocks' performance today? Credit Morgan Stanley's Scott Devitt, who downgraded Twitter to underweight -- analyst-speak for "sell" -- while raising his price target for Facebook (Devitt maintained his overweight, or buy, rating on Facebook). A week ago, I pointed out that more analyst downgrades of Twitter were likely, and I don't expect Devitt's to be the last.

In justifying the Twitter downgrade, Devitt wrote that "as competition for online ad dollars intensifies, we guide investors to Google (NASDAQ:GOOGL) and Facebook, dominant platforms with more attractive risk/reward." When it comes to advertising, reach matters and there is no denying that Google and Facebook are dominant in the areas of online search and social networking. According to its IPO prospectus filed on Nov. 4, Twitter has 230 million active users, compared with 1.2 billion for Facebook as of Sept. 30 (874 million for Facebook mobile products alone).

When Devitt refers to a "more attractive risk/reward," he is alluding to the gap in the valuation placed on Twitter and the two dominant platforms -- to Twitter's disadvantage. Indeed, Google is now valued at an enterprise value equal to 4.9 times the next 12 months' revenue estimate against 14.2 times for Facebook. The equivalent multiple for Twitter? An egregious 36.7.

In theory, it would be possible to justify such an oceanic gap if Twitter had growth prospects that were commensurate with the success of Google and Facebook; after all, Google's enterprise value was valued at 44 times trailing-12-month revenues as recently in March 2006.

However, one ought to be justifiably skeptical that Twitter will achieve the same widespread adoption. As Devitt points out in today's note, "despite the ease at which users can sign up for Twitter, we think it is inherently more complicated to understand how to get the most out of Twitter compared to Facebook's service, which is easier to use." Journalists get it -- they have to, as it has become a working tool for many of them -- so Twitter receives enormous media exposure, but it doesn't seem to me to have the same mainstream appeal as Facebook.

Whether a mechanical result of a low trading float or the product of investor euphoria, or some combination of both, Twitter shares finished 2013 massively overvalued. I don't see the business fundamentals catching up with the valuation this year -- expect Twitter shares to struggle. Facebook, though far from cheap, is for investors looking for exposure to social networking.

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Fool contributor Alex Dumortier, CFA, has no position in any stocks mentioned; you can follow him on Twitter @longrunreturns. The Motley Fool recommends Facebook, Google, and Twitter and owns shares of Facebook and Google. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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