Despite it's premium valuation, shares of growth stock Facebook (NASDAQ:FB) have appreciated 5% this year, even as the overall market declined. Why are investors so willing to reward Facebook with such an incredibly forward-looking valuation?
Facebook stock isn't cheap
With a market capitalization of about $313 billion at the time of this writing, and a price-to-earnings ratio of 85, shares of the world's largest social network trade at a significant premium to other large tech companies. For instance, the average P/E ratio for stocks in the tech-heavy Nasdaq 100 index is 21. And the average P/E ratio for stocks in the S&P 500 is 23.
Part of this premium valuation, of course, is simply because the social network is growing fast. In Facebook's most recent quarter, for instance, revenue and net income soared 52% and 122%, respectively.
Still, a P/E ratio this high leaves little room for potential problems, such as rapidly decelerating growth or rising costs as a percentage of revenue. So, why are investors so generous with Facebook's valuation?
Here are two likely reasons:
1. Growth is accelerating recently. For three quarters in a row, Facebook's quarterly year-over-year revenue growth rates have actually been increasing. Year-over-year revenue growth in Q2, Q3, and Q4 was 39%, 41%, and 52%, respectively.
In a comparison in contrast, investors couldn't say the same about fast-growing social network company Twitter. Twitter's year-over-year revenue growth rates have been declining since mid 2014.
The fact that Facebook has been able to -- at least temporarily -- reverse the deceleration of its revenue growth, provides investors incremental confidence in the social network's ability to maintain high growth rates over the long haul. Conversely, Twitter's consistent trend of decelerating growth could have some investors wondering when the deceleration could begin to moderate.
2. User growth is strong. Even at 1.59 billion monthly active users, Facebook's monthly active users continue to grow strongly. Indeed, the social network's sequential growth in monthly active users has largely remained at the same level during the last two and a half years. This is notable considering Facebook's already enormous reach.
For comparison, Twitter's growth in monthly active users has been decelerating rapidly. And in the social network's most recent quarter, sequential growth actually came to a halt.
Not all growth is created equal
Both Facebook and Twitter are growing rapidly. But Facebook's growth appears steady and Twitter's uncertain. This has the market viewing both company's differently.
Facebook's combination of reaccelerating revenue growth and its strong user growth, has investors confident in the company's ability to execute and its potential to continue growing rapidly over the long haul.
Meanwhile, Twitter's stock price has plummeted 63% during the past 12 months, even as fourth-quarter revenue jumped 48% from the year-ago quarter. The company's deteriorating growth has investors uneasy about management's ability to execute.
Recent stock moves aside, investors clearly value Facebook's business more than Twitter's. The larger social network's price-to-sales ratio is 17.4. Twitter's is five.
It's worth noting that the market's confidence in Facebook doesn't automatically make the stock a buy. But this analysis of what investors love about Facebook stock shows that there are sometimes great reasons for one fast-growing company's outsized premium valuation compared to another's.
Daniel Sparks has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Facebook. 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.