By the numbers: Facebook

Facebook looks mildly overvalued.

After looking at BBRY in my previousdetailed study, I decided to take a look at Facebook to understand what made sense as a reasonable valuation for the firm. As I started looking at the latest annual and quarterly filings, I learnt a lot of new things about the organization that I did not know.

To start with the firm has a ridiculous number of Shares that it used for compensation in the pre-IPO days when it was low on cash. With the IPO, much of those shares were converted to cash used to pay employees, but the tax implication of that move also had to be borne by the company. It used some of the proceeds from the IPO to pay taxes on employees share based compensation. This operating expense will impact free cash flows for next 3 years.

The firm has impressive numbers in terms of growth, but in many markets it is nearing saturation. It needs to find new revenue sources from existing customers to justify its market price. At this point, the IPO price of $38 looks completely out of reach.

The basis of growth

Facebook has had meteoric growth in terms of adoption and that may probably explain why its IPO was probably the largest in history. Many investors bought the stock at its opening bell price set at $38. At the time it was tough to foresee if the internet company could ever justify the valuation. Facebook measures its business in terms of a few key metrics.

These are

1. Monthly Active Users (MAU): Users that access their account atleast once a month, on mobile or on a PC.
2. Daily Active Users (DAU): Users that access their account once a day, on mobile or on a PC.
3. Ratio of DAU/MAU: This provides a metric on engagement and ofcourse an opportunity for Facebook to earn revenue.
4. Advertising Revenue: Revenue earned by click or view only ads, similar to Google
5. Payment and Fee Revenue: Amount paid for by users for stuff like games, Facebook currency and so on.
6. Social Revenue: Money earned by Facebook through new social engagements like sending gifts and priority posts
7. Average Revenue Per User: Average money earned per user as a percentage of Monthly Active Users

Projecting the engagement

My first task was to take the key performance indicators given and project them for next 5 to 6 years. Here is what the numbers look like. I am only showing the next couple of quarters projected. The actual calculation projects till end of 2018.

		Jun 29, 2012	Sep 29, 2012	Dec 30, 2012	Mar 30, 2013	Jun 1, 2013	Sep 30, 2013
US and Canada
Internet Population (in millions)	MAU (in millions)	186	189	193	195	196	197
273	DAU (in millions)	130	132	135	139	141	143
Total Population (in millions)	DAU/MAU	69.89%	69.84%	69.95%	71.28%	72%	72%
347	Adv. Revenue (in millions)	$479	$538	$631	$552	$577	$599
	Payment+Fee (in millions)	$111	$99	$149	$127	$128	$131
	Social Revenue (in millions)	$0	$0	$0	$0	$2	$1.52
	Total Revenue (in millions)	$590	$637	$780	$679	$707	$732
	ARPU	$3.20	$3.40	$4.08	$3.48	$3.61	$3.72
Europe
Internet Population (in millions)	MAU (in millions)	246	253	261	269	277	285
518	DAU (in millions)	154	160	169	179	188	197
Total Population (in millions)	DAU/MAU	62.60%	63.24%	64.75%	67%	68%	69%
739	Adv. Revenue (in millions)	$294	$295	$374	$367	$377	$401
	Payment+Fee (in millions)	$52	$46	$66	$56	$62	$65
	Social Revenue (in millions)	$0	$0	$0	$0	$1	$1.28
	Total Revenue (in millions)	$346	$341	$440	$423	$441	$468
	ARPU	$1.43	$1.37	$1.71	$1.57	$1.59	$1.64
Asia
Internet Population (in millions)	MAU (in millions)	255	277	298	319	340	361
1034	DAU (in millions)	129	141	153	167	180	194
Total Population (in millions)	DAU/MAU	50.59%	50.90%	51.34%	52%	53%	54%
3922	Adv. Revenue (in millions)	$115	$133	$168	$176	$181	$199
	Payment+Fee (in millions)	$20	$21	$30	$21	$28	$30
	Social Revenue (in millions)	$0	$0	$0	$0	$1	$1.30
	Total Revenue (in millions)	$135	$154	$198	$197	$210	$230
	ARPU	$0.55	$0.58	$0.69	$0.62	$0.62	$0.64
Rest of the world
Internet Population (in millions)	MAU (in millions)	268	288	304	327	347	366
469	DAU (in millions)	139	152	161	180	195	210
Total Population (in millions)	DAU/MAU	51.87%	52.78%	52.96%	55%	56%	57%
2009	Adv. Revenue (in millions)	$104	$120	$156	$150	$163	$180
	Payment+Fee (in millions)	$9	$10	$11	$9	$12	$13
	Social Revenue (in millions)	$0	$0	$0	$0	$1	$1.30
	Total Revenue (in millions)	$113	$130	$167	$159	$176	$194
	ARPU	$0.44	$0.47	$0.56	$0.49	$0.51	$0.53
Worldwide
	MAU (in millions)	955	1007	1056	1100	1,101	1,209
	DAU (in millions)	552	584	618	665	675	755
	DAU/MAU	57.80%	57.99%	58.52%	60.45%	61%	62%
	Adv. Revenue (in millions)	$992	$1,086	$1,329	$1,245	$1,299	$1,473
	Payment+Fee (in millions)	$192	$176	$256	$213	$234	$261
	Social Revenue (in millions)	$0	$0	$0	$0	$5	$5
	Total Revenue (in millions)	$1,184	$1,262	$1,585	$1,458	$1,533	$1,624
	ARPU	$1.28	$1.29	$1.54	$1.33	$1.39	$0.74
Total Quarterly Revenue		$1,184	$1,262	$1,585	$1,458	$1,533.23	$1,623.89

Valuation

Based on the above projections, the fair value of the stock seems to be $22.

Here are some key assumptions

1. Terminal Value of the stock is reached in Year 6
2. Revenue increases Year over Year till Year 6 is based on individual growth rates in each geography. The MAU and DAU increase till they cap at 75% of the Total Internet users in each geography.
3. Cost of Revenue is a rolling percentage of the Revenue based on historic averages
4. Operating expense needs to cover the Tax burden from the $2.11 B tax liability that will be settled in the next 3 years. It matches historic averages after that.
5. Annual Depreciation is $500K except Year 3 when it is $1M
6. Tax rate is 30% each year except next 2 years when its 41 and 35% respectively.
7. Most importantly, the annual revenue is based on the growth in each market based on DAU, MAU and ARPU growth/ decline. .
8. Beta is 1.4
9. Debt Financing Rate is 1.46%
10. Equity Financing Rate is 6.3%
11. Terminal Value estimates
    1. Growth becomes 2% after Year 5
    2. Alternatively, stock price stabilizes at 9.5 P/E based on Year 5 revenue.
    3. Actual Terminal value was mid point between these 2 estimates

	Year -1	Year 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
	FY 2011-2012	FY 2012-2013	FY 2013-2014	FY 2014-2015	FY 2015-2016	FY 2016-2017	FY 2017-2018	FY 2018-2019
Annual Revenue	$3,711,000	$5,089,000	$6,336,188.16	$7,448,706.63	$8,386,708.40	$9,263,159.32	$10,031,310.87	$10,558,525.73
Cost of Revenue	$860,000	$1,364,000	$1,698,283	$1,996,470	$2,247,882	$2,482,796	$2,688,683	$2,829,992
Operating Expense	$1,095,000	$3,187,000	$2,411,000.00	$2,290,450.00	$2,748,540.00	$1,946,113.00	$1,848,807.35	$1,756,366.98
Total Other Income/ Expenses Net	-$19,000	$7,000	$510,000	$20,000	$20,000	$20,000	$20,000	$20,000
Total costs	$1,955,000	$4,551,000	$4,109,283	$4,286,920	$4,996,422	$4,428,909	$4,537,490	$4,586,359
Net Income	$1,737,000	$545,000	$2,736,905	$3,181,787	$3,410,287	$4,854,250	$5,513,820	$5,992,167
Depreciation	$323,000	$649,000	$1,000,000	$1,000,000	$2,000,000.00	$1,000,000.00	$1,000,000.00	$1,000,000.00
EBIT	$1,737,000	$545,000	$2,736,905	$3,181,787	$3,410,287	$4,854,250	$5,513,820	$5,992,167
EBITDA	$2,060,000	$1,194,000	$3,736,905	$4,181,787	$5,410,287	$5,854,250	$6,513,820	$6,992,167
Tax rate	41.00%	91.50%	41.00%	35.00%	30.00%	30.00%	30.00%	30.00%
EBITDA X (1 – Tax rate)	$1,215,339	$101,514	$2,204,774	$2,718,161	$3,787,201	$4,097,975	$4,559,674	$4,894,517
Capital Expenditure	$606,000	$1,235,000	$500,000	$500,000	$1,000,000	$1,000,000	$500,000	$500,000
Delta Net Working Capital	$350,000	-$290,000	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000
Free Cash Flow	$582,339	-$194,486	$2,604,774	$3,118,161	$4,687,201	$3,997,975	$4,959,674	$5,294,517
Beta		1.40
Debt Financing Rate		1.46%
Equity Financing Rate		6.30%
Discount Rate		10.28%
Assumed Discount Rate		10.28%
Number of outstanding shares		2,372,705,195
EPS		-0.08
NPV@10.28% of FCF's Year 1 to Year 6		15,336,689
Terminal Value Estimates
Perpetual Growth at 3%		$72,726,878.41
Assumed PE of 10		$59,921,667.84
Assumed Terminal Value		$66,324,273
PV of Terminal Value		$36,871,598
Total Value		$52,208,286
Current Value Per Share		$22.00
Projected Value Per Share		$6.46

Conclusion

The stock has to fall 10% more from its current price of $24.30 to reach its fair value. A lot now depends on next few quarters on how well Facebook its able to monetize its offerings.