Now that Facebook Inc.’s (FB) new-product rollout has ended the suspense, there is only one question Facebook investors or potential buyers of the stock need answered: Can the company reliably increase its profits by more than 25% a year for the better part of the next decade?
This is the same primary question, in fact, that burned brightest during Tuesday's unveiling of "Graph Search," and every day since Facebook’s May 2012 IPO. If the answer is 'yes', then Facebook’s current share price near $30 is justifiable, based on the fundamentals. If this growth rate is within easier reach following the introduction of Graph Search, a tool for summoning information from the store of related users’ data on the site, then the stock’s 60% surge in the last three months may not be so wildly overdone.
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But if the answer isn’t clear - if Facebook’s path to 25%-or-better earnings growth is unlikely, or subject to too many competitive stresses and strategic stubbed toes along the way - it becomes hard to see the stock as anything but lavishly expensive.
That doesn’t mean the stock can’t continue climbing back toward or beyond the $38 IPO price, or that it must decline much from here. It simply means that an outsized portion of the long-term potential appreciation is already reflected in the share price.
Here’s the math underlying this evaluation: Facebook is projected to post operating earnings per share in 2013 of 66 cents, up 27% from an expected 52 cents in 2012. (These numbers actually overstate Facebook’s profitability, because they exclude stock-based employee compensation. Most tech-company estimates follow the same practice, though Facebook’s stock-payment costs are far higher than average.)
The 30-plus analysts who cover the stock, with not a Sell rating among them, collectively forecast this 25-30% earnings-growth clip will persist for the next five years. If the company plays to this upbeat script and grows the bottom line 28% annually, operating earnings would reach $2.27 a share in calendar-year 2018.
A generous but plausible large-cap growth-stock price/earnings multiple of 20 on that figure equates to a $45 stock. That would mean a 50% gain over more than five years - a positive but middling 7% annualized return, with plenty of help from favorable assumptions. This is at least the sort of growth priced into the stock, given its current P/E of 45-times 2013 earnings. While only about half the multiple afforded much smaller competitor LinkedIn Corp. (LNKD), a forward P/E above 40 is quite high for a company of Facebook's imposing size.
Such multi-year forecasts of how a large, fast-evolving company will develop -- and what a vagarious market might pay for it -- are necessarily rough and unsatisfying as guides to short-term investment decisions. But as a broad gauge of how much the market has already paid up for a great deal of uncertain future success, they can serve as a useful complement to sales-driven hype, noise over privacy settings and wiggles in ad pricing.
Facebook vs. The World
Comparisons to a couple of other leading tech giants when they’d reached a similar size to Facebook’s current $65 billion market value are also intriguing.
The dream scenario for Facebook bulls is that Mark Zuckerberg can take his company along the road cut by another, older iconoclastic, Wall Street-disdaining CEO founder: Jeff Bezos of Amazon.com (AMZN).
Amazon first reached Facebook’s current $65 billion market value in the fall of 2009, with Amazon stock around $135, some 12 years after its IPO. Coincidentally, in 2009 Amazon had about $1.2 billion in operating earnings, roughly what Facebook is estimated to have earned last year. Amazon was an expensive stock then and is far pricier today, having doubled to $270 for a P/E multiple of 156 on anticipated 2013 profits.
This doesn’t at all mean Facebook should pivot to e-commerce. More generally, it suggests that if it is to win the perpetual benefit of the doubt from investors in the form of a towering valuation, it would mean persuading the market that Facebook is an omnivorous juggernaut on an assured journey to take over vast swaths of the consumer economy. This perception is the only way to explain Amazon's huge valuation premium.
This is easier said than done, of course, and that much tougher given Facebook is mainly attacking advertising, payment-facilitation and gaming dollars rather than all of retail and media. Yet the fact Facebook got to its current heft at a much younger age, and has a more profitable model (for now), is worth noting.
Quite in contrast, eBay Inc. (EBAY) right now has a nearly equal $68 billion market cap. The company is a maturing, but steadily growing, e-commerce and payments leader. Its operating income is roughly triple Facebook’s (meaning its stock is about one-third as expensive).
As its PayPal business grows toward becoming a majority of eBay’s earnings, the stock’s valuation, now at 19-times 2013 earnings, should be supported well, given the stout multiples the market applies to big payment networks. If Facebook traded at eBay’s current multiple, the stock would be below $15.
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There is little doubt that Facebook has more open road in front of it at the moment than eBay, which itself faces plenty of challenges in payments and online retailing. And there's no denying that the data trove from Facebook’s nearly 1 billion users is among the more unreproducible assets in all of business.
But that doesn’t mean it’s an easy call to project whether or when the company will ever sufficiently realize the financial value of all those interactions - or what the fickle market will pay for the business along the way.