Facebook's (FB 0.82%) short history as a publicly traded company has been a wild one. Going public in 2012 at $38, a price that many mocked as a return to the irrational dot com bubble valuations in 1999 and 2000, shares quickly fell as low as $18 later that year as investors pondered the company's future in a mobile environment. Since then, Facebook stock has skyrocketed to levels that are more than twice as high as the IPO price. Here's some background on the story of Facebook stock and, more specifically, a look at whether it's a good value for investors today.
Facebook's monstrous growth
The source of Facebook stock's wild volatility since it went public can be summed up in one word: mobile. The social network went public during the Internet's big transition from a desktop-dominated environment to the multi-screen environment dominated by smartphones and tablets.
When Facebook stock began trading, the social network had zero revenue coming from mobile. Investors weren't sure whether this growth company could continue to beef up its bottom line in a mobile environment. Investors wondered: Could the social network effectively monetize the smaller mobile screens users were spending increasingly more time on? Could a little blue app really support a $100 billion valuation?
Little did anyone know that Facebook's little blue app was about to turn into a mobile money machine. Ads on Facebook's mobile platform ended up being even more engaging than those served on desktop. As soon as the company introduced mobile ads, advertisers spent unprecedented amounts on social advertising.
With video ads, one of Facebook's newer mobile advertising products, investors are hoping the social network can tap into marketers big budgets for TV ads. Image source: Facebook.
Mobile continues to be a huge driver for Facebook. To put the growth Facebook has seen from mobile advertising revenue in perspective, consider that the social network's mobile advertising revenue is up from $656 million and 41% of total advertising revenue in the year-ago quarter to $1.66 billion and 62% of total revenue in the company's most recent quarter.
This trend underlines the company's overall growth story. Total Facebook revenue in Q2 2014 is up 61% from the year-ago quarter and profits are up an impressive 147%. Reporting $1.39 billion in profits in Q2 alone, the company looks nothing like the ones that fell victim to the irrational dot-com bubble valuations.
The stock looks pricey
This sort of growth and success can only be bought at a premium valuation. At a market capitalization of $200 billion, Facebook has a price-to-earnings ratio of 84. With this sort of premium to earnings, the market expects the social network not only to continue growing revenue at impressive clips for years to come, but also to benefit from continued operating leverage.
How will operating leverage help Facebook? The scalability of Facebook's business means that operating income growth (and hence earnings) will probably outpace revenue growth for at least several more years. Just how important will operating leverage be in helping Facebook grow operating income in the coming years? After the growth that should continue to come from big marketers continuing to shift larger portions of their marketing budgets to Facebook ad spend, operating leverage could be the social network's next most important growth driver.
So, Facebook stock is definitely expensive -- but not as expensive as traditional financial metrics like price-to-earnings make the stock look at first glance. A deeper dive reveals that there is good reason to believe that Facebook's earnings could continue growing at year-over-year rates that exceed 50% the next four quarters, and year-over-year rates that exceed 30% over the next five years. Indeed, the consensus analyst estimate for Facebook's average annual earnings growth over the next five years is 38%.
Facebook's growth potential truly deserves a hefty premium.
The underlying business has enduring characteristics
Making any forward-looking projection of a company's future is no better than gambling if a company doesn't have enduring characteristics. So what makes Facebook's business enduring? One of the most powerful network effects the world has ever seen.
Facebook's network effect is the company's greatest competitive advantage. How does a network effect work? A network effect is what keeps users tied to a particular platform -- every additional user added to the network makes it even more valuable for existing members. When a platform benefits from a network effect, leaving the platform means leaving an active and useful network -- making switching costs for users high. For a competing social network to beat out Facebook, it would have to achieve the difficult task of persuading users to join a far less active platform and wait for their friends and family to switch.
To understand just how substantial Facebook's network effect is, consider that it has 1.32 billion monthly active users (up 14% from the year-ago quarter) and 829 million daily active users (up 19% from the year-ago quarter). Measured by daily active users, no other social network even comes close.
So, is Facebook stock good value today? The answer is tricky. While the company is healthier than ever and growth opportunities still look lucrative, the stock's very forward-looking $200 billion market capitalization seems to have priced much of this upside in. So investors who decide to buy shares today should probably keep their positions small to reflect the risk they are taking on. But the answer for current Facebook shareholders who may be considering selling is easier: Facebook's execution so far, combined with its opportunity for further earnings growth, definitely make the stock worth holding onto for the long haul.
