Forget Momentum: Facebook Presents an Opportunity

Facebook, like other "momentum stocks," have collapsed in a Nasdaq sell-off, but unlike its peers, does this loss now create a good investment opportunity?

Apr 7, 2014 at 11:30AM

Social media has been one of the hardest-hit industries in the market, with stocks like Yelp (NYSE:YELP), Twitter (NYSE:TWTR), and LinkedIn (NYSE:LNKD) now trading well off their 52-week highs. Yet, while many of these stocks are well-deserving of this pullback, Facebook (NASDAQ:FB) may be a company whose stock presents a good opportunity following these large losses.

What are you willing to pay?
No one's arguing that Facebook is undervalued, or that it couldn't fall lower, even after a 20%-plus decline from its all-time high. However, relative to its peers, Facebook may be fairly valued, and with its growth, that valuation may present an opportunity.

With that said, as momentum stocks continue to fall -- specifically in social media -- investors must determine the price they are willing to pay as these companies become cheaper. The chart below shows the current cost following the substantial losses within this space.

CompanyForward P/E Ratio
Facebook 33.9
LinkedIn 66.1
Yelp 183.5
Twitter 205.1

As you can see, Facebook is considerably cheaper than any of its peers, relative to one of the key metrics in determining value, which is a company's price times forward earnings. 

With Facebook's growth accelerating in each of its last four quarters last year, its total revenue growing 55% in 2013, and its operating margins at 37%, is 33.9 times forward earnings really that expensive? To answer that question, consider the lingering problems faced by Facebook's peers, and the multiples each of them are given.

More expensive despite more problems
At 66 times earnings, LinkedIn trades at a near 100% premium to Facebook. And while its 57% top-line growth was marginally better than Facebook last year, Sun Trust analyst Robert Peck has reminded investors that LinkedIn's guidance implies a 20% drop in revenue growth for 2014. That's a major drop for a company with such a pricey multiple.

Yelp has declined nearly 35% from its 52-week high in March, but as profiled in a previous article, much of that loss is in connection to a scandal regarding the company boosting the reviews for paying advertisers and punishing businesses who refuse to advertise on its site. Thus, with its entire business model being questioned -- and with 2,046 FTC complaints -- it'd be quite difficult to justify paying 183.5 times forward earnings.

Lastly, Twitter has lost more than 40% of its valuation since its post-IPO highs. These losses accelerated after its fourth-quarter earnings showed that Timeline views fell 7% versus the prior quarter, and its monthly active users grew only 4% in the same period. For a company trading at 205 times next year's earnings, it already looks as though its growth could be decelerating.

Is the forward earnings estimate accurate?|
With all things considered, Facebook looks like the best option. More important, 33.9 times forward earnings is not expensive for a company with this level of growth. However, there is another element to the equation, and that is the actuality of future earnings. 

For example, Twitter may trade at 205 times next year's earnings, but this is a company that has an operating margin of negative 95%. Therefore, it's tough to imagine Twitter improving enough to become profitable.

Facebook, on the other hand, will likely exceed EPS expectations. According to Yahoo! Finance, there are 42 analysts who cover Facebook, and the average EPS estimate for this year is $1.26. 

What's interesting about the $1.26 estimate is that it has been revised higher by only one penny in the last 60 days.  Yet, last month, Facebook announced the launch of its video advertisements, a service that consists of 15-second advertising slots sold to four advertisers for $2 million a day.

Using simple math alone, this could add nearly $3 billion to the company's revenue run rate. And as profiled in an article following Facebook's launch news, Facebook could top out with almost $15 billion in video advertising revenue, depending on price increases and the number of advertisers. This service is a new growth driver for the company, making its valuation that much more attractive. 

Final thoughts
There are two key elements in valuing Facebook today following the decline: First, it's significantly cheaper than its peers; second, video advertising has not been revised into EPS expectations Therefore, Facebook is likely significantly cheaper than 33.9 times forward earnings.

While Facebook may continue to fall with the Nasdaq sell-off, its losses should be seen as an opportunity. Meanwhile, peers Twitter and Yelp are simply correcting to levels that are more appropriate, and they could have a lot farther to fall. 

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Brian Nichols has no position in any stocks mentioned. The Motley Fool recommends Facebook, LinkedIn, Twitter, and Yelp. The Motley Fool owns shares of Facebook and LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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