Following up on the resolutions episode, this Industry Focus: Tech show is all about how investors can break down a company before they buy in.
Tune in as analysts Dylan Lewis and Michael Douglass share a four-step process for researching companies and their management, and then apply that framework to Facebook (FB +4.42%). Find out why it's so important to understand management's vision, where to find the important info about a company and some of the "intangibles" that can help separate a company from the rest of the pack.
A full transcript follows the video.
This podcast was recorded on Jan. 20, 2017.
Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, Jan. 20, and we're following up on our resolutions Tech show with a framework for analyzing a stock. I'm your host, Dylan Lewis, and I'm joined in the studio by the head of fool.com's financials and healthcare coverage, Michael Douglass.
Michael Douglass: Oh, hello!
Lewis: Michael, people enjoyed your appearance on last week's Tech show so much that you got an encore.
Douglass: "People" being primarily you. Which I appreciate.
Lewis: And one listener who reached out.
Douglass: Yes. This is the power of emailing us. If you reach out, we will absolutely devote a whole episode just to talking about whatever's on your mind. Generally.
Lewis: We are desperate and beholden to our dozens of listeners.
Douglass: [laughs] Yes.
Lewis: So, we got an email from, I hope I'm saying this right, John Bin. He loved the idea of having a more formal approach to analyzing a stock, and wanted to know exactly how Michael did it. This was something that we'd talked about on last week's resolutions show. So, I thought it made sense to bring you on, have you explained what that framework looks like, and have us apply it to a pretty well-known tech company, Facebook.
Douglass: Yeah, absolutely. This is the Tech show, we should probably talk about tech things at some point. Yeah, so, it was actually very helpful, because while I have a pretty time-intensive process, I hadn't actually previously written it down, so this is really good for forcing me to get organized and think through it. And the reason I have this time-intensive process is that I realized that my psychology as an investor is that I tend to get irrationally exuberant about about a stock, a story, a company, an idea. And it's great to get excited about things, but the thing I most need to do is slow myself down and make sure that I do this rigorous analysis to make sure that I am confident that the story I'm buying into is one that is really worth my money.
Lewis: So, this approach is really your speed bumps, your intentional speed bumps.
Douglass: Yes, exactly. So, your mileage may vary.
Lewis: [laughs] I think you made that joke last time, too, when we were talking about credit card rewards.
Douglass: Yeah, thanks. What can I say? Some people just repeat themselves. But, steps can be adjusted. There's no one-size-fits-all way to do this, but this is just how I approach it.
Lewis: Yeah. We're going to lay this out. There might be things that you think are more important when it comes to analyzing a company, or they're like, "Why didn't you include this?" If that's the case, email us at [email protected]. We'd be happy to hear about it.
Douglass: Maybe we'll just have a whole episode in which we apologize for things that we missed.
Lewis: [laughs] It might have to happen, who knows? Hopefully not. But, the thought here is, this is a framework, you can co-opt it, you can use bits and pieces of it. It's just a way to get yourself thinking and organize some of your thoughts.
Douglass: Exactly. I guess we'll start with that one. I think of this as a four-step process. Step one is to learn management's broad story. I think the first step to understanding a business is to understand how management explains it to the world. For you, philosophy nerds out there, hopefully it's not just me, I think of it like, Hegel has a thesis, antithesis, synthesis framework. You want to get that initial thesis from management, the antithesis will come later, and the synthesis is kind of your ultimate thoughts on the stock.
Lewis: For any listeners that feel bad about not understanding the Hegel reference, I will plead ignorance, I don't know it.
Douglass: Oh, OK sure. The idea is, you have one way of doing things, and a very different way comes, and long-term, the two get fused together. An example would be capitalism, communism, and then mixed economies, that's an example of Hegelianism. It doesn't always work, but sometimes it does.
Lewis: It sounds like a very appropriate way to look at things when you looking at the tech space.
Douglass: Yes, because you're going to have your bulls. Obviously, Facebook management, a little bit bullish on their own stock. You're going to have your bears. I think good investing is understanding both the opportunities and the threats.
Lewis: And the landscape changes so much within tech. You look back at Facebook in their time as a very well-known platform. They went from desktop primarily mobile, which is something we'll talk about a little bit more. Being able to make that pivot and be flexible and nimble is a big part of being able to survive.
Douglass: Yes. I think the questions I like to ask are things like, how does this company make money? What has management identified as the company's main growth drivers? How big are they? What does the opportunity look like five years out? What distinguishes this company from the competition? What threats have management identified, and what are they doing to minimize them?
Lewis: Why don't we run through some of those?! Facebook makes money via ads.
Douglass: Yes. They are, in fact, an ad platform.
Lewis: [laughs] I know you don't cover tech, I wasn't 100% sure --
Douglass: [laughs] Thanks for letting me know, Dylan. I appreciate that.
Lewis: In full transparency, Michael did a ton of the heavy lifting for the research on this show, so he's very well-versed in Facebook.
Douglass: Shucks, thanks.
Lewis: But, yeah, some 90% of their revenue comes in via ads. 84% of their total ad revenue comes from mobile. So they are heavily reliant on mobile. A long time ago, people were worried about their ability to pivot to a more mobile-oriented browsing experience for users. They've clearly done a very good job of that.
Douglass: Yes, and that's great, because frankly, mobile is where your growth is going to be. Desktop just long-term isn't going to do nearly as well as mobile.
Lewis: And it's an easy way for some of the more developing markets to gain connectivity, right?
Douglass: Exactly. So, that's definitely a big plus for their movement on mobile. Talking about the company's primary near- and long-term growth drivers. Facebook has a three-, a five-, and a 10-year plan.
Lewis: Which is excellent, by the way. They are a company that is very good at outlining what they're thinking.
Douglass: Yeah. I've seen a few other companies that do this, but not many. Usually, you have to cut through what management says to understand what they think, and then try to put numbers to that. I do appreciate that Facebook is pretty darn transparent about where they think things are going.
Lewis: Yeah, they're very blueprint-oriented. You'll see it here, and you'll also see it in how they decide to roll out and develop their platforms.
Douglass: Right. So, thinking about those near- and long-term growth drivers. Their three-year plan is, they're really focused on expanding the community they have, growing users. That makes sense. There are very clear business metrics tied to that. That's things like your monthly active users, your daily active users. You can see they're focused a lot on video, which boosts user engagement, which is interesting, frankly, it's difficult to click away from, I ought to know. [laughs]
Lewis: Yeah, it's very compelling. I catch myself all the time looking at videos by Tasty. Ugh, they're the worst. I don't know if you watch those in the Facebook Feed, but the food prep videos, they are so well-shot, and they look scrumptious.
Douglass: Yeah, it's brutal, especially when you're at the gym, and you're like, "You know what I don't need right now? To see this amazing mac and cheese."
Lewis: Or, use it as the motivation.
Douglass: Yeah, because you can have this afterwards?
Lewis: Exactly.
Douglass: That's worth a shot. Their five-year stuff, they're really looking at Messenger and WhatsApp monetization, beginning to monetize those. They're also looking at further monetization of Instagram, what they're doing with video, and also improving the search capabilities.
Lewis: And then, a little bit further out, 10 years. They have the grand ambition of basically growing internet access. Currently, somewhere between 3 billion to 3.5 billion people have access to the internet. The world population is over 7 billion. So, there are a lot of people who still do not have internet access, still do not have connectivity. A lot of the stuff Facebook is doing via internet.org is getting at that, and finding unique ways to bring mobile connectivity or even very limited connections to people in developing parts of the world.
Douglass: Right. And, also, they've done a few things that really sound moonshot-y. You hear about virtual reality, and you're like, "OK, cool." You hear about AI and you're like, "Yeah, Terminator, we've seen it." But the thing is, they have clear business outcomes tied to these. For example, with AI, part of their plan here, and there's a lot of optionalities you're able to imagine if you're able to put AI together, but, one of their clear current business metrics that they can drive with that is better curation of their feeds, to make sure those feeds are serving up the most engaging content possible based on the person. And you can see how that would really help grow engaged users, that would help grow how many ads those users see, how relevant those ads are. So, it really ties directly into the company's bottom line in a way that a lot of tech companies with moonshots don't do as well.
Lewis: The next bullet point within this section, what distinguishes this company from the competition? What do you see with them?
Douglass: Obviously, they're the largest social platform. And they appear to have really cracked mobile in a way that a lot of other people haven't. A lot of the internet is still very much struggling with mobile marketing, whereas 84% of Facebook's spend is coming from there. It's not hard to see that this is something that they've really done a good job with. I think, as well, the network effect. They have, what, three?
Lewis: Three properties: Facebook, WhatsApp, and Messenger. All have over 1 billion monthly active users.
Douglass: Right. So, you can just imagine, as each of those gets bigger, it gets stickier. If everybody you know is on Facebook, you're going to get on Facebook. That's why it's such a big deal when someone is like, "I'm going to deactivate my Facebook," because everybody is there.
Lewis: Yeah, the value proposition is so strong for existing users, and so compelling for people that were on the fence. To be like, "Ah, every single person I know organizes parties via Facebook Events, and I don't end up getting the invites, and now I don't get invited, and now I'm hanging out by myself on a Friday night."
Douglass: This is starting to sound a lot like a personal story, Dylan. [laughs]
Lewis: [laughs] No, no, I'm not bringing my personal life into this show at all. I have a Facebook account. I just don't want the record to show. [laughs] But yeah, they have those three properties with over a billion monthly active users. And, oh yeah, as a kicker, they have Instagram, which has over 500 million monthly active users. So, a very strong business with a lot of properties with a ton of potential, and a big, almost what I would think of as, an installed base.
Douglass: Yes. So, for this, the sort of resources I tend to look at are a webcast or transcript of the company's most recent presentation at an analyst conference, or an investor presentation or the annual shareholder call. Those are usually available on the investor relations sites. There's usually some presentation materials associated with them, so it's a good source.
Lewis: And those tend to be the times where management gets a little bit more vision-oriented and big picture. What we're going to talk about next is quarterly results, and the conference calls they do. Sometimes you get that flavor there. But very often, those are very metrics-oriented. So, what you might find is, and I see Facebook do this every now and then, they won't touch on the same things every call. So, you'll get an update on, maybe, the number of small businesses that have pages on Facebook every two quarters or something like that. That's where it can be helpful to look at annual reports or things like that, then use the quarterly reports as something to stay up-to-date on those things as they feel like sharing them.
Douglass: Yeah. If you think of it like a lasagna --
Lewis: [laughs] I can't wait to see where this metaphor goes.
Douglass: [laughs] The broad story is the pasta of the lasagna, the outer layered shell. Then, you have to fill it in with the meat of the matter, which is, how are they making money? That is what the quarterly calls do. Not too bad, right?
Lewis: That was much more cleanly executed than I thought it would be.
Douglass: [laughs] I'm not sure if that's a compliment or an implied insult, but I'll take it. So, some questions I like to ask, in case we didn't get it in the first part, like, how does this company make money? And I say that because a lot of companies will obfuscate. They'll be like, "We have these three big things we do," and one of them is 99% and the other two combine to 1%, so obviously I should only care about the first one right now, because the other two don't matter.
Lewis: And that's relevant to Facebook, right? I think maybe $200 million last quarter came in via payments and fees. It's a pittance. If you hear that's down 3%, you might think that something you should care about, but if you look within the context of the overall business ...
Douglass: Not so much.
Lewis: Yeah, they're really not relying on that.
Douglass: And that's why the 10-Q and the 10-K can be so helpful. Those can be found, if you just search "EDGAR," you'll find the SEC's website, where if you put in the ticker, in this case, FB, you can get all their filings with the SEC. That's where you can find these kinds of numbers. It's helpful to look at both of those together to understand both sides of it. I often ask, what numbers did management not emphasize in their presentations? Really, I felt they actually did pretty good accounting of stuff. But, sometimes, a management will skip over something and you'll see it in there, and it's kind of important. That's where the investigative reporting comes in.
Lewis: Yeah. I think it isn't so relevant to this discussion, but, using this framework to apply to other companies -- if you see management apply a unique non-GAAP figure to results --
Douglass: And GAAP is generally accepted accounting practices.
Lewis: Thank you for butting in. I appreciate that, I would have glossed right over that.
Douglass: Yep, I got your back.
Lewis: If you see someone highlighting a number that is not a standard number, have some questions about it. What you'll see sometimes is, they'll have this metric and they'll tout it for two quarters, and then it won't be such an appealing metric anymore and they will just stop mentioning it. So, those are the times where you have to scratch your head and look back and say, "What happened? How come they stopped bringing that up?" And see what that really says about the business results. There's the omission factor, and you want to dig in.
Douglass: Right. This gets to what is, broadly speaking, one of the underlying questions when you're investing, and it's something we'll get to more in step four -- do you trust management? If management is trying to pull wool over investors' eyes, guess what? Run away, because chances are pretty darn good...if you can't trust the story they're telling, that's a really big concern. So, always something to keep an eye out for. Another thing that gets to that as well that I often look at is, within their annual filings with the SEC -- so, their 10-Ks, companies have to disclose what their threats are. And sometimes management talks about these threats, and sometimes they don't talk about some of them, and it's always interesting to see which they emphasize and which they don't. So, I picked a few out of Facebook's 10-K that I thought mattered and a few that really don't matter as much, don't seem terribly likely. Because, they have to disclose all of them. Obviously, they're not going to talk about them, because some of them really are fairly minor.
Lewis: So, what makes the "matters" list?
Douglass: Philosophically, or the actual list?
Lewis: [laughs] The actual list.
Douglass: First one, failure to retain existing users or add new users. Yeah, that would be a big problem because they're an ad platform. But, fortunately, it's very clear that their metrics are good. Their monthly active users are up 16% year over year in the most recent quarter. Daily active users are up 17% year over year in the most recent quarter. Mobile is increasing faster, which is good, because the world is shifting toward mobile. So, all in all, that is a credible threat, it is a thing they are controlling for nicely.
Lewis: And those are pretty gaudy growth rates, and they're on denominators that are over 1 billion. So, they're doing pretty well when it comes to user acquisition.
Douglass: Right. They have another one which is basically, if marketers stop spending money on Facebook ads, that would be bad. Yes, yes that would. That's the whole business model. That said, Facebook is investing really heavily in analytics to help marketers get a very clean return on investment, or ROI calc, so they can understand, "I spent $5 in ads, and I got $8 in value. That's a calc we're comfortable with." I'm really impressed, actually, with how proactive they're being about that. I think that's a very good move.
Lewis: Yeah. And broadly speaking, I'm not super worried about the movement of ad dollars away from the Facebooks and Googles of the world. I think they're strong. A lot of advertisers have seen the money that they're pouring into those platforms prove out. That's why they continue to do this. I think you're just going to see those flows continue.
Douglass: Right. Another one, and we'll talk about maybe two more -- competition. When it comes to digital ad spend, Google is the top dog. Google is a credible threat. Although, frankly, in social, they haven't done so great with Google Plus. So, that is a credible threat, if Alphabet is ever able to muscle into social. But so far, they haven't been able to. That said, it's an important thing for them to keep an eye on, and I'm glad that they're doing so.
Lewis: And we talked about the network effect before. To a certain degree, that's a moat for Facebook that insulates them from some of these competitive risks. It's really hard to get over a billion people to stop using something.
Douglass: Right. Finally, ad blockers, that could be a concern. That said, the fact that they're moving toward the app, like you said, Dylan, is a good sign, because so far, at least, no one has figured out how to put an ad block within an app. But, inevitably, there's always going to be this thing where you have companies trying to make money and people trying to improve user experience, and they're always going to be yin and yang with each other. There's all this going to be some tension there. That said, so far, Facebook has actually profited from the movement away from desktop ads, which is rare and a good sign.
Lewis: Yeah. The control that being a stand-alone app for a smartphone gives Facebook is really incredible when it comes to ad blocking. Unlike when you are, say, accessing Facebook on Chrome, or accessing Facebook on Firefox, and you can have extensions that will run on top of the site and manipulate the user experience so that ads might not show up, you really don't have that type of access, that average consumer can't do that within a smartphone app. So, maybe that changes at some point. But, again, to a certain extent, they're insulated by that.
Douglass: Right. A couple examples of less important ones: new products could fail to make people happy, so they won't use them. Yep, that's life. They may not prioritize short-term financial results. That's not a bad thing. That's great. Just a couple examples of threats that you can, "Eh, OK, fair." Another question I'd like to ask is, is the story that management told in step one still on track? And, yeah. Very much so. Especially the three-step framework they have for approaching these apps. Phase one is a great consumer experience plus scale. Phase two is people interacting with businesses freely. For example, business pages on Facebook. Phase three is helping businesses reach people with that. If that's something they're able to roll out effectively on Instagram, and further down the line, hopefully, in some different way with Messenger and WhatsApp, then that gets very, very attractive.
Lewis: Yeah. That's another one of the blueprints that management is very good at talking about, very open about, and they're very clear with their investors and provide regular updates on the phases that these different properties are in. If you're looking for a risk in there, I think there is one. I don't think it's a huge, but I think there's a fundamental difference between Facebook and Instagram and WhatsApp and Messenger in how people use them and what their user experience expectation is. With Facebook and Instagram, people are posting. It's for public consumption, and there's this feed style to it. And that lends itself very well to in-feed, inline ads. When you're talking about messenger apps, it's a little bit different. You're not exactly sure what that looks like, but that approach isn't going to work quite the same way. So, on my end, I don't have any doubts that they are going to find a way to monetize those properties. But I do think they're going to have to be a little bit more creative about it.
Douglass: Yeah, totally. With that in mind, step three is basically, decide, do I like the business? With all this information, let me synthesize it, and basically say, "OK, cool, what's the overall story with the company?" We've already covered that, Dylan, so I'm just going to skip it. I think everyone knows at this point, it's ads. Heading back to step one, do we believe that management is accurate in their portrayal of where the company is and could be? I think the answer is yes. They seem very realistic. And I think the big question is, do we trust management? It's interesting because Mark Zuckerberg, as far as I can tell, is a visionary first and a businessman second. So, there's always inherently a little bit of a trade-off there, and that can be frustrating because business people will better monetize than visionaries. That said, for something as dynamic and difficult to stay in front of as social, he's clearly somebody who's thinking 10 or 15 moves, years, ahead, and that is exactly the person who I want steering the ship for the largest social network.
Lewis: And you see them as a business, and Zuckerberg too, recognize how important it is for him to be the helm, and for him to maintain control. You look back to the stock split that they announced in early 2016. We're still waiting for details on when that might execute, and some more specifics there. But, the company announced a 3-for-1 stock split. What that would do is, there are two existing share classes, A shares and B shares. Existing shareholders of those would get two C shares for each one they hold. Effectively, if you had one, you're getting three. Where this plays in to the ownership structure and control of the business is, A shares have one vote, B shares are supershares that have 10 votes, and C shares have no voting rights. They have the same economic value as the other shares theoretically. But, most of the shares that Zuckerberg owns are B shares. So, this stock split will allow him to give away shares to the charitable organization that he has set up, the Chan Zuckerberg Initiative, and still maintain control of the business, which I think is what you want as a Facebook investor. I don't know anyone that can really steer the ship for them any better than him.
Douglass: Yeah, they are not a candidate for an activist investor. I think they're exactly the sort of business that needs to be allowed to invest for the long-term and think through what they want to do.
Lewis: What goes into, once you've done all of this qualitative business look, what's this final step?
Douglass: Valuation is a sticky, tough thing. It's difficult to value a business. For me, what I tend to look for is, it depends very much on the industry. If you're talking REITs, you're going to go off funds from operations. If you're talking clinical-stage biotechs, you're going to go off peak sales.
Lewis: Gee, I wonder what industry you regularly cover.
Douglass: [laughs] I know, right? Interesting, a financial and healthcare company! If you're going off a profitable large-cap tech or consumer goods company, hint, Facebook, I'm kind of inclined to go for just P/E (price to earnings), looking at it is compared to where the S&P is, and what the growth rates look like compared to the S&P. Facebook is trading at around 48 times trailing-12-month earnings as of right now, and around 25 times forward EPS (earnings per share).
Lewis: Which is a big drop off.
Douglass: Yes, and it's a sign of just how quickly analysts expect them to grow. For me, at least, to find this company attractive, and this is different for everyone, but I want to see revenue and earnings grow at least 20% a year over at least the next five years, to feel comfortable buying at that valuation. Fortunately, Facebook is growing a heck of a lot faster than that, having increased revenue by, what, 50% or so last quarter. Obviously, that's good. Keep in mind, they're not going to be increasing ad load further. That means the number of ads in the feed won't be increasing further. That's part of what that growth has been. But, for them to slow down to 20% revenue and earnings growth, ad load would have to be a majority of their ad growth, and shut off, and a bunch of other things would have to go wrong. I feel pretty good about that not happening. So, I'm pretty confident they can get to that.
Lewis: One of the things that I always think it's good to look at when you thinking about growth expectations and what your shares can do, and what the ceiling for growth is, is to consider the market cap. This is something our boss, Anand Chokkavelu, always reminds me of. Currently, Facebook is a $370 billion company. For them to double would be taking them to about the current size of Apple. I think they have a ton of growth avenues available to them, and that's something that could certainly play out over the next couple years. But, you look back, they doubled over the last two years. And I think some people looking at them as a business will say, "They did that in two years, so it's reasonable to see them do it again fairly quickly." The important thing to keep in mind is, the larger you get, the harder it is to have growth that really meaningfully moves the business. So, I'm with you. I think it's a great business. I think growth is going to keep happening. But, keep in mind that it might not be at the same clip that it's been over the past couple years, particularly as they look to monetize platforms that are a little different than their core namesake one, and another one, Instagram, that's very similar to it.
Douglass: Totally, and I think that's exactly correct. That's why I went with that 20% number, because it's so much less than they have been. I think it's pretty reasonable to think that they may be able to beat that. I will say, having done this analysis, I am not a Facebook shareholder. I am planning to become a Facebook shareholder at some point in the near future.
Lewis: Yeah, I'm in the same boat. I had made the resolution in early 2016 to own at least one FANG stock, and I would up buying Alphabet last year. I've sat on the sidelines for Facebook for a while, but when I look at what their forward earnings valuation is, and the clip they've been growing at, and what they would need to justify that, it seems like there's still a pretty big runway ahead of them.
Douglass: Yeah. That's the hope, anyway. I guess we'll just have to see how it pans out. But, thanks again for the listener question, because it led to me living out part of my resolution to analyze at least one stock a month. I've knocked that off, which is good because January's ending before too much longer. Hopefully that'll be something I'm actually able to keep to for the rest of the year, as well.
Lewis: For a resolutions show callback, it turns out John Bin is your accountability buddy.
Douglass: [laughs] No, I'm pretty sure that's still you.
Lewis: [laughs] Oh, it's still me? All right. Well, listeners, that does it for this episode of Industry Focus. If you have any questions, or you just want to reach out and say, "Hey," shoot us an email at [email protected]. You can always tweet us @MFIndustryFocus. Like Michael said, we love to get those messages, and it winds up turning into a show more often than not. If you like the show and you're looking for more of our stuff, subscribe on iTunes, or you can check out The Fool's family of shows at fool.com/podcasts.
As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. For Michael Douglass, I'm Dylan Lewis. Thanks for listening and Fool on!
