Don't Turn the Page On Facebook Just Yet

Richard Saintvilus's picture

Friday, December 2, 2016 - 9:30am

by Richard Saintvilus

Is the Facebook, Inc. (Nasdaq: FB) story still intact or is time to turn the page?

As with several other technology stocks, shares of the social media giant have been under heavy selling pressure ever since Donald Trump's surprise victory. Both retail and institutional investors have abandoned high-growth stocks like Facebook in favor of banks, industrials, and biotechs.

Where Facebook Stands
In the case of Facebook, it's debatable how much of the stock's recent decline has to do with investors shifting out of tech and into other areas. The shares have fallen as much as 15% since reaching a 52-week high of $133.50 on October 25 after management spooked investors in the third-quarter conference call by warning that ad revenue growth will slow in the quarters ahead. Add in the fact that Facebook hinted of high capital expenses in 2017, which may yield lower earnings per share, and investors quickly moved on to looking for the next great stock.

Those who have stuck with the company are now questioning their decision on the heels of recent missteps such as misreporting video ad metrics and a failure to deal with fake news. All of that said, it's still too early to pass a verdict of Facebook and say that its best days are behind it. From a valuation perspective, the stock is currently trades at an attractive discount not only to its organic earnings growth potential, but also on the basis of the company's ability expand its margins, which will boost the bottom line in coming quarters.

Valuation Seems Attractive
The consensus earnings per share (EPS) estimate for fiscal 2017 currently stands at $5.21 per share, according to analysts polled by Thomson Reuters. Estimates for fiscal 2018 have risen to $6.56 per share. In both cases, analysts have steadily increased their EPS forecast over the past three months. And there is nothing to suggest that their bullishness will wane soon. Assuming Facebook does earn $5.21 per share in 2017, this would translate to year-over-year growth of 27.4% compared to 2016 estimates of $4.09 per share.

These measures would put the company on track to grow earnings at 26% in fiscal 2018, assuming the company actually does earn $6.56 per share. From a valuation perspective, Facebook shares -- currently around $121 -- are priced at just 23 times forward estimates of $5.21 for 2017, while valued at 18 times fiscal 2018 estimates of $6.56. This compares favorably to the 17 forward P/E for the S&P 500 (SPX) index. But how many S&P 500 stocks can deliver average earnings growth of 26.7% in the next two years?

And here's the thing: Assuming Facebook meets Wall Street's 2016 estimates of $4.09 per share, which would be 79% year-over-year EPS growth above 2015 levels of $2.28, Facebook would have to average 44% earnings growth through 2018. What's more, Wall Street expects the company to grow earnings by an average annual rate of 32% in the next five years. This means after 2017 and 2018, analysts expect Facebook's rate of growth to re-accelerate. And the stock only costs a premium of six points above the rest of the market today. Sound like an excellent bargain, doesn't it?

2017 Investments Should Pay Off
Facebook's management called 2017 an investment year, which was interpreted by some investors as "lower profits" when, in fact, the company is saying it will use revenue to grow the business, strengthen its products, and keep users engaged. With 1.8 billion worldwide users and 4 million active advertisers, Facebook understands that its lifeblood hinges on its ability to keep those users interested on the platform

While the company did hint that ad revenue growth will slow, that's not the same as Facebook accepting the result. The company can avert the ad revenue decline or even accelerate growth by investing in assets such as Messenger, which the company continues to build out. Plus, Facebook continues to explore ways to better monetize Instagram and WhatsApp. Its Workplace platform, aimed at attracting professionals similar to LinkedIn Corporation (Nasdaq: LNKD) is another potential catalyst.

Combine all that with Facebook's Marketplace, the company's answer to Etsy, Inc. (Nasdaq: ETSY) and Ebay Inc. (Nasdaq: EBAY), which helps users buy and sell goods with people in their community, and I think Facebook's 2017 investments are poised to pay off in 2018. How can I be so sure? Facebook has established a cycle of heavy investments that have been followed by big stock gains the year after. Facebook declared 2013 an investment year that followed solid gains in 2014. After ramping up its investments in 2015, Facebook stock shot to all-time highs in 2016.

Will 2017 investment year deliver sizable 2018 stock gains? It's tough to bet against CEO Mark Zuckerberg.

Risks To Consider: Chief Accounting Officer Jas Athwal recently resigned at the company -- a move some consider related to recent errors in reported advertisers metrics. The change might not impact Facebook materially, but it does suggest that the company is concerned about recent criticism. FB stock may also continue to suffer as the market digests the impact of President-elect Trump's economic policies and determine which sectors become more favorable. Technology is not yet on the list.

Action To Take: Facebook should be kept on the watch list of investors who are looking for high-growth technology stock that is trading at a meaningful discount to its long-term potential.

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Richard Saintvilus does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.