Is There An Opportunity With Facebook, Inc.'s (NASDAQ:FB) 33% Undervaluation?

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="How far off is Facebook, Inc. (NASDAQ:FB) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today’s value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!” data-reactid=”19″>How far off is Facebook, Inc. (NASDAQ:FB) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today’s value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.” data-reactid=”20″>We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content=" Check out our latest analysis for Facebook ” data-reactid=”21″>Check out our latest analysis for Facebook

Is Facebook fairly valued?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:

10-year free cash flow (FCF) estimate

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$271b” data-reactid=”28″>(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$271b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case we have used the 10-year government bond rate (1.7%) to estimate future growth. In the same way as with the 10-year ‘growth’ period, we discount future cash flows to today’s value, using a cost of equity of 7.4%.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Terminal Value (TV)= FCF₂₀₂₉ × (1 + g) ÷ (r – g) = US$61b× (1 + 1.7%) ÷ 7.4%– 1.7%) = US$1.1t” data-reactid=”30″>Terminal Value (TV)= FCF₂₀₂₉ × (1 + g) ÷ (r – g) = US$61b× (1 + 1.7%) ÷ 7.4%– 1.7%) = US$1.1t

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$1.1t÷ ( 1 + 7.4%)¹⁰= US$535b” data-reactid=”31″>Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$1.1t÷ ( 1 + 7.4%)¹⁰= US$535b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$805b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$190, the company appears quite good value at a 33% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.

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Important assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Facebook as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we’ve used 7.4%, which is based on a levered beta of 1.042. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.