The major social media stocks were among the biggest beneficiaries of the mobile device boom. Many social media companies sprang up, seemingly out of nowhere, and became billion-dollar businesses out of our collective desire to connect and share with each other.
Social media giant Facebook (FB) grew so fast, that it became one of the largest publicly-traded companies in the world. The stock has fallen considerably in the past year, due to privacy and security concerns, as well as worries over slowing growth.
But after a 22% year-to-date decline in the share price, the sell-off may have gone too far, as the company continues to grow earnings at a high rate. Facebook shares could represent a compelling value at these reduced prices.
Investors Give Facebook A Thumbs-Down
Facebook is the unquestioned leader in the social media industry. In the most recent quarter, Facebook reported nearly 2.3 billion monthly active users. What’s more, almost 1.5 billion people use Facebook every day. This type of engagement is a gold mine for advertisers, which explains Facebook’s soaring revenue and profits over the past several years. In 2017, Facebook generated $40.65 billion of revenue, up from $7.87 billion in 2013. As a result, earnings-per-share soared from $0.60 in 2013, to $5.39 last year.
However, Facebook has endured multiple scandals in recent months, that have eroded investor sentiment. In March, multiple news outlets reported that a company called Cambridge Analytica, a British political consulting firm, had used data from more than 50 million Facebook users without their permission. More recently, Facebook revealed a data breach that impacted 30 million users, of which 14 million had their personal information exposed.
Facebook is seeing elevated headline risk, which has tarnished its reputation, both among users and investors. Add to this that the company’s revenue and active user totals missed expectations last quarter. All of this explains the steep drop in Facebook share price from its 52-week high. However, Facebook continues to generate growth.
Facebook: Cash Machine
It is easy to see why Facebook stock has performed poorly this year. Still, Facebook remains in strong financial position overall. Despite reporting lower-than-expected user growth last quarter, the company still posted 33% revenue growth and 11% earnings growth for the quarter. It is reasonable to think that the company may not be able to sustain its extremely high rate of growth from years past, particularly in future generations use Facebook less. Social media is a fast-moving and highly competitive space. Platforms that become hugely popular with one generation may not necessarily be as popular with the next.
But Facebook is not at that point yet. There are many international regions which have been slow to adopt Facebook, leaving open the possibility of continued user growth. Facebook is also furthering its ambitions in video and other strategic growth areas. Plus, from an investment perspective, Facebook is a cash machine. The company generated $12.04 billion of free cash flow in the first three quarters of 2018. Its huge cash flows have piled up on the balance sheet. Facebook has $41.21 billion of cash and marketable securities on the balance sheet, compared with $12 billion in total debt. The company can utilize its cash hoard to invest in growth, pursue acquisitions, or perhaps even pay a dividend to shareholders at some point in the future.
Facebook’s impressive fundamentals indicate the stock is undervalued, particularly at its reduced level. With a recent share price of $138, Facebook shares exchange hands for 18.8x this year’s consensus earnings-per-share of $7.36. Fair value for Facebook stock could be a price-to-earnings of 20x, which would still be a lower valuation than the broader S&P 500 Index. If Facebook stock traded for 20x earnings, the corresponding increase would fuel 1.2% annual returns to shareholders.
In addition, Facebook could reasonably be expected to grow earnings by 10% per year over the long-term. As a result, the combination of an expanding stock valuation and earnings growth, could fuel annual returns in excess of 11% per year. Returns could be even higher, if company earnings or the stock valuation increase at a higher-than-anticipated rate.
Selling Pressure May Have Gone Too Far
Investor sentiment has turned negative toward Facebook this year. But in this case, the decline in Facebook’s share price is due to unfavorable headlines, and not a real deterioration of the business.
As long as Facebook continues to generate earnings growth, the stock should deserve a higher valuation. Value investors could see reason to like Facebook shares here.
Ben Reynolds is CEO of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth stock portfolios for the long run.