This article is intended to be food for thought. I rate Facebook (NASDAQ:FB) a strong buy. There are a few reasons to buy this company. A person only needs one reason to buy a stock and I give at least three reasons in this article.
Ad Spending Only Grows
Throughout history, merchants have worked hard to get information about their products on top of customers’ minds. Town criers, carnival barkers, signs in front of the shoppe. These advertising techniques advanced to billboards, radio ads, and technology has now delivered location-based mobile phone notifications to help us get what we want and get it when it’s most convenient.
Maybe I’m a little ahead of the curve on location-based notifications you say? I don’t get those on my phone yet you say? Well you will get them soon says mdgadvertising.com’s article on The Future of Proximity & Micro-Location Marketing.
Anyway, it’s clear advertising spend only grows (check out the graph from Bloomberg below). Facebook controls your family scrapbook and your mobile phone, so there’s no way their platform won’t continue to engage customers. Hence, the company will be sought out by merchants looking to spend their growing ad dollars. Here’s a graph of ad spending and GDP to prove out the point:
Ad Spend Moving Digital
The trend in advertising is evidently, “go digital or go home.” In 2016, annual digital ad spending surpassed television advertising for the first time. Research firm Magna forecasts the 2017’s spending on digital ads to increase by 16% and weigh in at a whopping $70 billion for the year (by about $10 billion).
Forward projections for advertising mix indicate the dominance of digital as a component of total ad spend:
In 2016, GroupM said, digital captured 72 cents of every new ad dollar spent, while TV captured 21 cents. The split will tilt even further in digital’s favor in 2017, with digital winning 77 cents per new dollar, compared with 17 cents for TV.
If Facebook captures just 30% of new U.S.-based ad spending on digital, they’ll realize revenue growth of 10% for the year, indicating they are on track to continue growing earnings.
P/E Over 40 Only Means Buy Harder
Clearly, Facebook is trading at a high price-to-earnings ratio which has typically exceeded 40 times annual earnings throughout the company’s history as a publicly listed stock. It’s true most stock purchased at P/Es over 40 end up generating subpar returns. But really, this time it’s different. I mean, at least with Facebook, right?
So I need to justify my Strong Buy rating. It’s only my opinion. Nonetheless, the reason Facebook is a strong buy is because I see this being a $150B per year revenue earner with strong profit margins in 20 years from now. That’s for sure. Because of ad spend’s growth, right?
So at $150B per year and a 20% profit margin. That’s definitely attainable because this is a software and networking business with relatively low capital requirements. Now, we’re looking at net earnings of $30B each year down the road. At a standard low-growth multiple on a large cap of 20 times earnings that makes for a $600B market capitalization for Facebook.
Wow! That’s 600B dollars valuation compared to today’s $400B market capitalization. To the strong credit of the Board of Governors, Facebook has a pretty conservative amount of dilution rate in its total shares outstanding, so the price per share appears likely to increase 50% from here under this scenario.
What If Facebook Makes Even More Than 20% Profit?
Now if Facebook beats an estimate of 20% profit margin into perpetuity, things will be even better for its stockholders. Most companies don’t make 20% margins into perpetuity, although if history is any guide, Facebook sure will! Their profit margin in 2016 measured at 36.98%. So they’d really have to mess up not to keep making 20% in the 20th year where our valuation’s earnings projection resides.
Facebook Risky Based On Interest Rates?
Here is one risk for Facebook, and I’m not hedging anything here, I’m just saying this because I want to present a fair and balanced viewpoint here.
When interest rates go up, corporate profits drop, and maybe ad spending slows down if, and I mean if the economy ever has a setback ever again (which seems unlikely because Donald Trump is president). Here’s a graph made by some smart statisticians proving my point: Interest rates up, Corporate Profits down:
Source: The Financial Times
Now you can see where higher interest rates made the pink mountain grow, indicating increased interest expenses. And the teal mountain (representing Corporate Profits) shrinks when interest expenses increase. Pretty obvious right. Well since interest rates appear to be on track to go up, maybe some corporations will pull back ad spending. But remember the graph above, every time ad spend has reduced with a recession it has always gone up again!
So is a recession a risk to Facebook stock? Not really, if you just buy and hold without a margin call.
According to the profit margin projection and revenue growth expectations, Facebook’s stock price is on course to increase by 50% over the next 20 years. Therefore, I rate this stock a Strong Buy.
Disclaimer: This article is intended as food for thought, is delivered as-is, and in no way is this investment advice to any person or entity. This article does not include my investment opinion but does include insight into Facebook’s business opportunity. Subscribe to the RETAIL MEGAPHONE premium service and access my library of opinion articles.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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