Meta Platforms (Facebook): Time to Buy the Dip?
Fundamental analysis and Discounted Cash Flow valuation of Meta Platforms (Facebook, Instagram, Whatsapp)
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DISCLAIMER: The publication expresses my own opinions. Information presented is for educational purposes ONLY and does NOT intend to make an offer or solicitation to sell or purchase any specific securities, investments, or investment strategies.
Introduction
Since last Thursday, the 3rd of February, Meta Platforms (previously known as Facebook) announced that it expects revenues in Q1 2022 to miss Wall Street’s expectations. According to Mark Zuckerberg, the reason is attributable to its users spending more time on other platforms such as Tik Tok.
The announcement made the price fall by over 20% overnight, and it now stands around 40% off its all-time highs. This sudden price drop lured many retail investors into buying the dip. As reported by Reuters:
“Investors on Fidelity's online trading platform placed four buy orders for every sell order, with the social media company topping the list of most-traded stocks.”1
This article will analyse the opportunities and risks ahead for Meta and translate them into a discounted cash flow model.
Company Overview
Meta Platforms is an advertising company, and it makes money by selling its users’ attention. Its business model is incredibly profitable. The marginal cost of showing one additional ad is almost zero, but the companies purchasing it need to bid against each other to get one. For this reason, Meta showed persistent high gross, net income and FCF margins for almost a decade.
The company has been so successful because it has access to a massive amount of personal information from a vast pool of users. Consequently, Meta can identify its users’ needs and wishes and show them the perfect ad at the perfect time. As a result, the companies that buy ads on Facebook and Instagram can reach a wider audience and enjoy a higher conversion rate.2
In addition, thanks to its 3.9 billion monthly active users, Meta enjoys a significant network effect that creates a moat around its operations. Before competing against Facebook & Co, a competitor would need to reach this user level. Not impossible, but very hard. For this reason, Meta had a return on capital above 15% for the past five years.
Opportunities And Risks Ahead
The tailwind towards a fully digitalised economy is still blowing strong, and the Covid-19 pandemic only accelerated the process. While users continue to switch their purchasing habits online, more and more companies will build their online presence. As a result, the demand for advertising space will keep increasing, boosting Meta’s revenues.
In addition, Zuckerberg is betting strongly on the metaverse. At the Facebook Connect virtual reality conference, he said:
“Today we are seen as a social media company, but in our DNA we are a company that builds technology to connect people, and the metaverse is the next frontier just like social networking was when we got started”
If Zuckerberg is correct, and the people start to spend more time in the metaverse, Meta Platform will expand its corporate life cycle and accelerate its revenue growth rate once again. Firstly, being the first big player in the “new world” will allow Meta to generate a network effect and build a new moat around the company’s operations. Secondly, the immersive reality of the metaverse will enable a more engaging advertising format, increasing the conversion rate. Consequently, Meta could charge higher prices.
Mark Zuckerberg still owns 12% of the company, and most of his wealth is tied to the company’s future. For this reason, Meta’s shareholders can assume that whichever direction the company is taking, it could be well-aligned with their long-term interests.
Unfortunately, the road ahead is bumpy and full of risks.
The first risk is regulation. For over a decade, Facebook freely used its users’ data to provide high-quality targeted ads. However, regulators worldwide are starting to raise concerns about how the company is handling this data. As a result, new regulations are probably coming. Just a couple of days ago, Meta announced that it might shut down Facebook and Instagram in Europe if it is not given the possibility to move, store, and process data from European users on US-based servers.
The threat is not only coming from regulators but also competitors such as Apple. With its new privacy settings, Apple is limiting the tracking of its users from third parties. As a result, Meta has access to less information, the targeting of its adverts is less precise, and their value decreases.
The second risk comes from its size. Meta is too big, and this could lower the growth opportunities ahead. The US and European antitrust are already questioning the size and power of Meta, and they won’t allow it to buy new companies. As a result, the previous strategy of just buying the competitors won’t work anymore, as it did with Instagram and Whatsapp. In the future, users’ attention will be divided between multiple platforms not owned by Meta.
The last risk comes from Meta’s biggest opportunity: the metaverse. If it doesn’t take hold and people stick to the usual social media, Meta will fail to expand its corporate life cycle and fall into the mature, stable phase.
My personal opinion on the metaverse is that it won’t take hold, at least not in the nearest future.
Which problem does the metaverse solve? We are already over-connected with each other thanks to our phones and laptops. The metaverse would only change it to a more immersive experience. However, I think this is more a limitation rather than an advantage.
With the existing technology, we can connect and multitask from everywhere. You can check your Instagram for 5 minutes between your meetings, have a call while walking in the street, or text your friends while on the train. All of this is not possible in the metaverse. You need to stay at home and wear your VR Set to enter it. You need to be fully immersed in the new world. No metaverse while walking, on the train, or doing other things. I see the metaverse more as the future of gaming rather than social media or social life as a whole. If true, the total addressable market (TAM) size would be way smaller and, with it, the revenue-generating potential of Meta Platforms.
Lastly, even if it takes hold, Meta will hardly be the first player as it was with social media. Several companies are already operating in the metaverse, such as Sandbox and Roblox.
How Much Is Meta Platforms Worth?
According to its Enterprise Value/Total Revenue, Meta Platforms is trading at its lowest valuation of the past ten years. Also, it just became cheaper than Alphabet (Google) and Twitter.
However, I don’t think Meta’s low relative valuation is a strong enough reason to buy it. The multiple is contracting because the business is approaching its mature phase where growth slows down and margins contract. It’s normal that a mature company trades at lower multiples. The best way to evaluate whether Meta Platforms is trading at a discount is to build a discounted cash flow model.
Discounted Cash Flow Valuation
As opposed to the valuation based on multiples, a discounted cash flow model is based on projections and expectations about key value drivers such as revenue growth, operating margins, reinvestment rate and risk.
To estimate the revenue growth rate, I take the digital Ad Spending worldwide 2020-2025 estimates provided by Insider Intelligence. They expect the total online advertising market to grow at a CAGR of 12.50% over the next four years.
I believe Meta will be able to keep its market share. Hence, its revenues will grow at the same rate as the whole market for the next five years. After that, I expect it to slowly move towards the economy’s rate.
After adjusting for R&D expenses, the company operated with an EBIT margin of 45% in FY 2021. However, increasing competition and new regulations will inevitably push down Meta’s prices and increase expenses. As a result, I expect Meta’s operating margin to linearly adjust towards 25% in year five and to settle at 20% in the terminal year.
The company is operating at a Sales to Capital ratio of 1.2, and I expect it to lower to 1 for the next ten years. Finally, I calculated a cost of capital of 8.46% for the next five years, moving towards 7.35% in the terminal year.3
The following table shows the resulting Free Cash Flow to the Firm over the next ten years.
Summing the present value of all future cash flows, adding cash and subtracting debt results in an enterprise value of around $ 532 billion or $ 195.55 per share.
Scenario Analysis
The main limitation of the discounted cash flow models is that even a small change in the assumptions could change the estimated fair value. For this reason, I ran a scenario analysis to compare the possible outcomes of different growth rates and operating margins from the years 6 to 10.
If the metaverse takes hold and Zuckerberg succeeds in being the first player, I expect Meta to grow at a higher rate than the market and keep its high operating margin. The resulting valuation would range between $ 260 - 288 per share.
Conclusion
In conclusion, although Meta Platform’s price fell more than 30% from its all-time high, I believe the company is still overvalued by about 10%.
Unlike Amazon and Google Search that show ads exactly when the users look for specific products (intent marketing), Meta needs private information to display relevant ads. Consequently, Meta’s success is strictly related to the regulation around users’ data. As a result, if the company wants to extend its corporate life cycle, it will need to find a way to offer high-quality advertising without extensive tracking. I find it a huge risk going forward, and I would like to see a considerable discount before buying Meta.
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Link: https://www.reuters.com/business/meta-plunge-slams-wall-street-retail-investors-buy-dip-2022-02-03/
Conversion rate = the percentage of clients who buy after seeing the ad.
Inputs: Beta 1.1; ERP 6%; Debt ratio 2% 1-5y, 10% after; after tax cost of debt 1.95%; risk free rate 2%.