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Facebook Inc Is Brilliant

By Ashraf Eassa – Feb 21, 2014 at 4:00PM

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Facebook is in the unique position of having a richly valued stock and an investor base that doesn't mind excessive purchases in the name of growth.

Facebook (META -0.86%) trades for a market capitalization just north of $170 billion. Given that the company generated $2.86 billion in free cash flow over the last 12 months, the stock trades at a pretty rich 59.44 times free cash flow. It's extremely expensive and highly dependent on growth that may ultimately not materialize, but the stock is what it is. And Facebook, cognizant of how much power Wall Street has given it, is taking full advantage of it to build its moat.

$19 billion? Doesn't matter
The WhatsApp purchase cost Facebook $19 billion -- $4 billion in cash, the rest in stock. While many investors -- including, it seems, the majority of the sell-side -- will balk at this purchase, it's hard to ignore that Facebook can essentially print as much of this money as it wants. Notice how even following the purchase of this clearly overvalued chat app, Facebook shares are down a mere 2.28% in the pre-market session, representing $4 billion in market capitalization, or the cash portion of the deal?

Facebook has the power to use its very expensive stock to buy whatever competition it needs in order to widen and deepen its competitive moat. Since Facebook's shareholders seem to have absolutely no problem with the company using the stock to buy whatever it thinks it needs, then what does it matter how much Facebook paid? It could have been $19 billion or $29 billion -- it wouldn't have mattered. Facebook can issue shares at will, and its shareholders approve.

What about long-term?
The problem here is that Facebook actually feels the need to acquire all of these small, competing apps. If Facebook's ecosystem were so sticky, would it really need to dilute its shareholders significantly just to pick up a chat app that generates less than $1 per user in annual revenue? Is such a small-fry app really such a threat to Facebook's core business?

Facebook will probably be allowed, by virtue of an expensive stock, to continue its strategy of aggressive purchases as long as the company's core business continues its strong revenue growth. Will this prove enough to really build a "moat?" Only time will tell, but it's clear that Facebook is being very opportunistic with what it has today in order to secure its tomorrow.

Foolish bottom line
At a $175 billion market capitalization, it's tough to see how much more room there is for Facebook's stock to run on any sort of rational valuation basis. However, the laws of supply and demand are much more powerful in the markets than anything else. As a result of this deal, you will see that on any meaningful dip, investors who "missed out" on the run will jump on so that they can capture the next leg up. Whether there are enough investors still on the sidelines at this point will determine what the stock will do in the months to come. 

Ashraf Eassa has no position in any stocks mentioned. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. 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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