A popular metric for sizing up stocks is return on equity, or ROE, which measures a company's profits as a percentage of shareholder's equity. The higher that percentage, the more efficient a company is at generating profits with its equity capital base. Since profitability and leverage levels vary wildly across industries and companies, investors should always compare a company's ROE to its direct industry rivals.
In the social media industry, revenue and user growth often take precedence over profitability, so unprofitable players like Twitter (NYSE:TWTR) and LinkedIn (NYSE:LNKD.DL) currently have a negative ROE. Yet other social media companies -- like Facebook (NASDAQ:FB) and Yelp (NYSE:YELP) -- have positive ROE ratios. Let's see what makes these two players different from their industry peers.
In addition to being the largest social network in the world, Facebook is also the most profitable. Last year, its GAAP net income rose 96% annually to $2.94 billion. As a result, Facebook's ROE of 10.8% is the highest among the "big four" social media stocks, which also include Twitter, LinkedIn, and Yelp.
However, Facebook's ROE started declining last year due to a dip in profitability. Over the last three quarters, Facebook's operating expenses respectively rose 41%, 87%, and 83% annually. During that period, its operating margin declined from 44% to 26%.
Last July, CEO Mark Zuckerberg told investors that the company would continue to "invest heavily" in expanding its ecosystem, as it previously did by buying Instagram for $1 billion, WhatsApp for $19 billion, and Oculus VR for $2 billion. Facebook has also heavily invested in its own video hosting, internal news publishing, mobile payments, and AI platforms to disrupt Google's (NASDAQ:GOOG) (NASDAQ:GOOGL) sprawling ecosystem. All those efforts plant the seeds for Facebook's future growth, but they could weigh down Facebook's profitability and ROE in the near term.
However, Facebook's robust revenue growth could partially offset that pressure. Last quarter, its revenue soared 42% annually, thanks to strong demand for its ads. The company's unconventional strategy of throttling the number of ads every quarter inflated market demand, causing its average price per ad to spike 285% annually last quarter as it served 62% fewer ads.
Business review site Yelp has had a tough year. The stock has fallen more than 50% over the past 12 months, due to a streak of disappointing earnings and concerns that larger players like Facebook and Google will render its services obsolete. Yelp also recently sent shareholders on a roller coaster ride by shopping itself around but failing to find a buyer.
Last quarter, Yelp's revenue rose 55% annually to $118.5 million, which missed the consensus estimate of $120 million. It reported a net loss of $1.3 million, a considerable improvement from a loss of $2.6 million a year earlier. However, analysts had expected Yelp to post a profit of about $878,000. Yelp's unique visitors on mobile and desktop platforms rose 8% to 142 million, but it still has a much smaller social footprint than Facebook or Twitter. Sales from international markets still account for less than 3% of Yelp's top line.
Despite those challenges, Yelp has a positive ROE of 6.7%, since it reported a full-year profit of $36.5 million last year. However, $26.2 million of that came from booking an income tax allowance during the fourth quarter. As a result, Yelp's current ROE is inflated, and might slip this year as the income tax allowance fades in the rear view mirror.
Looking ahead, Yelp is trying to grow its top line by adding analytics and customer interaction features for businesses, expanding overseas, and bolting on new features like video uploads for users. Unfortunately, all those upgrades caused its total costs and expenses to surge 52% year-over-year to $123 million last quarter, which swallowed up its $119 million in revenues.
Don't depend on ROE alone
ROE ratios can give investors a quick snapshot of a company's profitability, but they never tell a complete story. For a clearer picture of these companies and their social media peers, investors should compare ROE to other key metrics, like P/E, P/S, and free cash flow ratios. Additionally, companies that are highly leveraged with debt may report abnormally high ROEs, but that debt can carry significant financial risk.
Facebook's ROE might decline in the future, but only because it's investing in the growth of its ecosystem. Its bottom line will remain under pressure, but it's unlikely to dip into the red anytime soon. Yelp, however, doesn't have the revenue growth to support its rising expenses, so it could post more quarterly losses and cause its ROE to turn negative.
Leo Sun owns shares of Facebook. The Motley Fool recommends Facebook, Google (A shares), Google (C shares), LinkedIn, Twitter, and Yelp. The Motley Fool owns shares of Facebook, Google (A shares), Google (C shares), LinkedIn, and Twitter. 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.