Valuation of FB's development platforms

In my previous post, I had provided a list of development platforms that Facebook owns. The next thing to do is to do a valuation of these platforms to understand what these are worth and how it can add predictability to Facebook's earnings. To recap these offerings were grouped into the following categories:

1. Platform for Sharing Experiences
2. Platforms that Support Developers
3. Platform that allow advertisers to sell and position advertisements
4. Platform that allows developers to leverage the information being captured by all the interactions on the primary experience sharing platform.

Since the above would be termed as intellectual property, we need to understand how to value these items. Based on a Wikipedia article on valuation of Intellectual Property, the following are the methods one could use to value the above:

1. Cost approach: The cost approach is based on the economic principle of substitution. This principle states that an investor will pay no more for an asset than the cost to obtain, by purchasing or constructing, a substitute asset of equal utility. There are several cost approach valuation methods, the most common being the historical cost, replacement cost, and replication cost.
2. Market approach: The market approach is based on the economic principle of competition and equilibrium. These principles conclude that, in a free and unrestricted market, supply and demand factors will drive the price of an asset at equilibrium point. Furthermore, it provides an indication of the value by comparing the price at which similar property has exchanged between willing buyers and sellers.
3. Income approach: This approach estimates the fair value of intellectual property by discounting the future economic benefits of ownership at an appropriate discount rate.
4. Direct approach: The direct approach is based on the current value of shares of intellectual property in an Intellectual Property (IP) Share Market.
5. Using the pay-off method on top of the four above mentioned methods is a way to enhance the valuation and analysis of intellectual property.

In my future updates on this post, I will try and understand the impact of these platforms on the valuation of Facebook.

Facebook Competitive Advantages through its technology platforms and Architecture choices

Facebook operates the largest social network on the planet. It has over a billion users that use the site every month. Its primary strategy is to bring an ever increasing network of people together on its site. It makes money by selling advertisement and payment based services to end users.

Unlike Google whose primary competitive advantage is its search capabilities, Facebook provides the ability to connect among people in a context rich way so as to keep people engaged. Its users provide their friends and families on latest updates on what is happening as well as on sharing experiences with their friends and family.

Last year, I had written a post on FB's customer segmentation, where I mentioned the initial set of stakeholders that Facebook saw itself serving. It included Users, Developers and Marketers. At that point, it was not clear how Facebook's strategy translated to what they were doing on their platforms. A year down and in hindsight, it is becoming clear how Facebook has matched its platform architecture and capabilities to these groups. This allows us to understand Facebook platforms in the following way.

The overall Facebook platform allows the following services:

1. Platform for Sharing Experiences
2. Platforms that Support Developers
3. Platform that allow advertisers to sell and position advertisements
4. Platform that allows developers to leverage the information being captured by all the interactions on the primary experience sharing platform.

Lets understand these platforms a little bit more in detail, to eventually understand how they may perhaps impact future earnings of the organization.

Platforms for Sharing Experiences

Facebook has the following platforms for sharing experiences.

1. Login: A secure way for people to log into an application or website.
2. Share: Allowing users in third party application to post to Facebook from within the application.
3. Games: Allowing users to share their successes within a game with their Facebook friends and allow game developers to collect game statistics from users.

Platforms that Support Developers

To ensure that Developers are enticed to embellish their applications with Facebook features, Facebook has built some products that allow developers to build applications more easily. These include:

4. Payments: Allow app developers to collect payments online.
5. Parse: Allow app developers to develop applications that work across platforms and collect usage data
6. Ads for Apps: Allow App Developers to promote their applications on Facebook
7. Platform SDKs: These are Software Development Kits that allow developers to access Facebook APIs within different software development platforms.

Platforms that allow Advertisers to Sell and Position Advertisements

Since the bulk of revenue for Facebook is coming from advertisements, Facebook has the following capabilities for selling advertisements.

8. Primary platform: This platform allows advertisers to create their advertisements and place their bids for running advertisements or running campaigns.
9. Ads API: This platform allows advertisers to change their campaigns and other capabilities programmatically.

Platforms that allow Developers to Mine Information and Build new applications

10. Graph API: Graph API the primary API that allows users to insert information into the narrative for a user. Graph API also has a targeted search that exposes aspects of a user's private storyline to advertisers for positioning advertisements.

The above at a high level reflect my understanding of Facebook's platforms and components. The next step would be to figure how all of this supports the strategy and future cash flows for Facebook.

By the numbers: Facebook at end of Q4 2013

Facebook moving along.

In my previous posts on Facebook, I had looked at Facebook results for June 2013. Accordingly, I had projected the Free Cash Flow for the firm in the years to come. I had come to the conclusion that the stock was slightly overpriced. The calendar has moved along and we are now waiting for Facebook to release March 2014 earnings in late April 2014. As we wait, it would be a good idea to baseline our estimates based on December, in preparation for figues coming out in April.

The basis of growth

As mentioned in my previous posts, 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

I had earlier conservatively projected the numbers for the next few quarters, and then using these quarterly projections, I had projected the revenue over the next few years. In my previous post, Sept and December 2013 values were predictions. In the latest post, these have been replaced with actual figures posted by Facebook.

		Sep 30, '13	Dec 30, '13	Mar 30, '14	Jun 30, '14	Sep 30, '14	Dec 30, '14	Mar 30, '15	Jun 30, '15
US and Canada
Internet Population (in millions)	MAU (in millions)	199	201	202	203	204	205	206	207
273	DAU (in millions)	144	147	149	151	153	154	155	155
Total Population (in millions)	DAU/MAU	72.36%	73.13%	74%	74%	75%	75%	75%	75%
347	Adv. Revenue (in millions)	$832	$1,068	$1,301.41	$1,372.96	$1,498.72	$1,596.65	$1,680.02	$1,705.47
	Payment+Fee (in millions)	$130	$138	$136	$138	$140	$141	$141	$142
	Social Revenue (in millions)	$0	$0	$1.00	$1.26	$1.59	$1.98	$2.48	$2.85
	Total Revenue (in millions)	$962	$1,206	$1,438	$1,512	$1,641	$1,740	$1,824	$1,851
	ARPU	$4.83	$6.00	$6.44	$6.76	$7.35	$7.79	$8.16	$8.24
Europe
Internet Population (in millions)	MAU (in millions)	276	282	286	291	296	301	306	311
518	DAU (in millions)	188	195	200	207	213	220	226	233
Total Population (in millions)	DAU/MAU	68.12%	69.15%	70%	71%	72%	73%	74%	75%
739	Adv. Revenue (in millions)	$482	$658	$802.37	$861.72	$948.80	$1,025.25	$1,110.77	$1,148.26
	Payment+Fee (in millions)	$56	$69	$63	$65	$69	$72	$72	$75
	Social Revenue (in millions)	$0	$0	$1.00	$1.27	$1.61	$2.05	$2.60	$3.02
	Total Revenue (in millions)	$538	$727	$867	$928	$1,019	$1,099	$1,186	$1,226
	ARPU	$1.95	$2.58	$2.80	$2.96	$3.20	$3.41	$3.63	$3.70
Asia
Internet Population (in millions)	MAU (in millions)	351	368	384	399	416	431	447	463
1034	DAU (in millions)	189	200	211	222	233	245	256	268
Total Population (in millions)	DAU/MAU	53.85%	54.35%	55%	56%	56%	57%	57%	58%
3922	Adv. Revenue (in millions)	$255	$318	$279	$306	$329	$348	$355	$375
	Payment+Fee (in millions)	$23	$23	$26	$27	$28	$29	$31	$32
	Social Revenue (in millions)	$0	$0	$1.00	$1.28	$1.65	$2.11	$2.70	$3.17
	Total Revenue (in millions)	$278	$341	$306	$334	$358	$379	$388	$410
	ARPU	$0.79	$0.93	$1.02	$1.11	$1.25	$1.40	$1.56	$1.74
Rest of the world
Internet Population (in millions)	MAU (in millions)	362	376	392	408	423	439	454	470
469	DAU (in millions)	208	216	229	240	251	263	275	287
Total Population (in millions)	DAU/MAU	57.46%	57.45%	58%	59%	59%	60%	61%	61%
2009	Adv. Revenue (in millions)	$229	$300	$252	$278	$298	$317	$321	$339
	Payment+Fee (in millions)	$9	$11	$11	$12	$12	$13	$14	$14
	Social Revenue (in millions)	$0	$0	$1.00	$1.28	$1.64	$2.10	$2.69	$3.15
	Total Revenue (in millions)	$238	$311	$264	$292	$312	$333	$337	$356
	ARPU	$0.66	$0.83	$0.93	$1.05	$1.22	$1.40	$1.63	$1.87
Worldwide
	MAU (in millions)	1189	1228	1,265	1,301	1,339	1,376	1,413	1,450
	DAU (in millions)	728	757	785	814	843	873	903	933
	DAU/MAU	61.23%	61.64%	62%	63%	63%	63%	64%	64%
	Adv. Revenue (in millions)	$1,798	$2,344	$2,635	$2,819	$3,074	$3,287	$3,466	$3,567
	Payment+Fee (in millions)	$218	$241	$236	$242	$249	$255	$258	$263
	Social Revenue (in millions)	$0	$0	$4	$5	$6	$8	$10	$12
	Total Revenue (in millions)	$2,016	$2,585	$2,875	$3,066	$3,330	$3,551	$3,735	$3,843
	ARPU	$1.70	$2.11	$2.27	$2.36	$2.49	$2.58	$2.64	$2.65
Total Quarterly Revenue		$2,016	$2,585	$2,875	$3,066	$3,330	$3,551	$3,735	$3,843

Valuation

Based on the above projections, the fair value of the stock seems to be $44.

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 $500M except Year 3 when it is $1B
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 1.772 as per the latest numbers
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 0	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6
	FY '13-2014	FY 2014-2015	FY 2015-2016	FY 2016-2017	FY 2017-2018	FY 2018-2019	FY 2019-2020
Annual Revenue	$7,872,000	$12,831,845	$15,470,567	$16,539,783	$17,608,621	$18,616,172	$19,477,406
Cost of Revenue	$1,875,000	$3,056,365	$3,684,872	$3,939,544	$4,194,127	$4,434,111	$4,639,245
Operating Expense	$3,193,000	$3,033,350	$3,640,020	$2,793,019	$2,653,368	$2,520,700	$2,394,665
Total Other Income/ Expenses Net	$6,000	$20,000	$20,000	$20,000	$20,000	$20,000	$20,000
Total costs	$5,068,000	$6,089,715	$7,324,892	$6,732,563	$6,847,495	$6,954,811	$7,033,910
Net Income	$2,810,000	$6,762,129	$8,165,675	$9,827,220	$10,781,126	$11,681,361	$12,463,496
Depreciation	$1,011,000	$1,000,000	$2,000,000	$1,000,000	$1,000,000	$1,000,000	$1,000,000
EBIT	$2,810,000	$6,762,129	$8,165,675	$9,827,220	$10,781,126	$11,681,361	$12,463,496
EBITDA	$3,821,000	$7,762,129	$10,165,675	$10,827,220	$11,781,126	$12,681,361	$13,463,496
Tax rate	46.00%	35.00%	30.00%	30.00%	30.00%	30.00%	30.00%
EBITDA X (1 – Tax rate)	$2,063,340	$5,045,384	$7,115,972	$7,579,054	$8,246,788	$8,876,953	$9,424,447
Capital Expenditure	$1,362,000	$2,000,000	$4,000,000	$1,000,000	$500,000	$500,000	$500,000
Delta Net Working Capital	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000	$100,000
Free Cash Flow	$1,612,340	$3,945,384	$5,015,972	$7,479,054	$8,646,788	$9,276,953	$9,824,447
Beta	1.40	1.77
Debt Financing Rate	1.46%	1.46%
Equity Financing Rate	6.30%	6.30%
Discount Rate	10.28%	12.62%
Assumed Discount Rate	10.28%	12.62%
Number of outstanding shares	2,407,000,000	2,407,000,000
EPS	1.17	2.81
FCF per Share	0.67	1.64
NPV@10.28% of FCF's Year 1 to Year 6	28,913,770	32,442,999
Terminal Value Estimates
Perpetual Growth at 3%	$134,951,200	$106,000,357
Shareprice at time of Analysis	56.75	56.75
Current P/E using GAAP Diluted EPS	246.74	246.74
Current P/E using Non-GAAP Diluted EPS	157.64	157.64
Assumed PE of 20	$186,952,443	$194,940,737
Assumed Terminal Value	$160,951,821	$150,470,547
PV of Terminal Value	$89,477,811	$73,749,378
Total Value	$118,391,581	$106,192,377
Current Intrinsic Value Per Share	$49.19	$44.12

Here is how the valuation would vary based on the long term P/E ratios the market wants to give

Projected EPS	$2.81
Average Revenue Growth over next 5 years	1.26
Market P/E	48.50
Stock price	$136.25

Conclusions

The stock has an intrinsic value of $44 which is quite sensitive to the stock's Beta at 1.77. If the volatility comes down the stock price will most likely go up.