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Are Traditional Valuations of Facebook Reasonable?

Traditional valuation techniques don't factor in the problems facing Facebook due to the uncertainty of the new regulatory environment that will likely adversely affect its future earnings

Facebook Inc. (NASDAQ:FB) CEO Mark Zuckerberg faced hostile questions from lawmakers yesterday during his appearance before a joint session of the Senate Commerce and Judiciary Committees. Although he may have assuaged investor concerns for the moment, questions still remain about how the Cambridge Analytica scandal and subsequent revelations about misuse of customers’ private data will affect the long-term financial health of the company.

Despite the cascade of bad news, some analysts and fund managers remain undaunted. In their view, the fundamentals of the company remain strong and the current crisis will abate over time. Indeed, many of the company’s bellwether financial benchmarks are enviable.

The stock’s current price-earnings ratio is 30.6; earnings per share are $5.39; return on equity is 23.88% and its net margin is 39.2%. Facebook’s earnings growth over the last five years has been explosive. The company earned $1.5 billion in 2013. At the end of 2017, its earnings had skyrocketed tenfold to $16 billion. These numbers are not indicative of a company in peril.

Yet, ominous signs are emerging that do not bode well for the company.

First, Fakebook’s entire revenue stream from operations was predicated on unfettered access to its customers private data that it sold to advertisers and other undisclosed third parties, in some cases, without its users’ consent or knowledge. Stripped bare of its idealistic claims of being a platform for spawning online communities, Facebook was nothing more than a giant — and highly profitable — advertising clearinghouse.

Second, the significance and unprecedented nature of Zuckerberg’s appearance before the Senate Commerce Committee should not be lost on analysts. How often has a CEO of a Fortune 500 company been compelled to testify before Congress about their company’s ordinary and every day business practices?

Zuckerberg’s interrogation before legislators is a seminal event because it signifies unequivocally that the era of laissez-faire is over, not just for Facebook, but for every other major internet company. The specter of certain regulation is especially acute for Facebook because of all the members of the FAANG group, it is clearly the most vulnerable. Any anticipated changes or legislative responses to address privacy concerns will fundamentally alter the manner in which Facebook conducts its core business.

Traditional valuation techniques do not, and perhaps cannot, acknowledge or address these imponderable variables that, however indeterminate, will have a substantial impact on earnings. Give present uncertainties, any discounted internal rate of return projection for Facebook would be speculative.

Facebook’s unorthodox business practices have upended traditional fundamental analysis. The company is perhaps singularly unique among corporations in the Dow Jones Industrial Index in that its sole product is its users. For purposes of security analysis, can the same be said of Monsanto Co. (MON) of The Boeing Co. (NYSE:BA)?

Facebook’s most substantial asset is private information extracted from its users. This is reflected in the company’s book value of $25.59 per share versus Tuesday’s closing price of $165.04. How does one ascribe a present value to an asset that will now be depleted over time? Its current operating margin of 50% doesn’t reflect the “true” cost of doing business. Given recent scrutiny by lawmakers and consumers alike, those who think these hefty operating margins will continue are wishing upon a star.

Moving forward, Facebook will not be conducting business as usual. In light of the public furor precipitated by callous disregard for its users’ privacy, regulations are a certainty. Facebook’s very business model is under assault and will not survive intact. Since data harvesting has been the bedrock of Facebook’s business, there is no viable solution to remedy the problems that created the public backlash without impacting adversely the company’s profitability.

Some have argued new rights to privacy should be legally recognized that would prohibit companies like Facebook from using private information without an individual’s consent. New models for user interaction with Facebook would entail revenue sharing that would additionally crimp the company’s growth rate.

Because the greatest risks facing Facebook are cultural, legal and political, its current predicament presents difficulties that are insurmountable. The company will not be able to sustain its present rate of growth while operating in a regulatory environment that curtails its ability to harvest and manipulate customer data.

Given these new and inexorable realities, is a Piotroski F-Score of 8 for the company truly warranted? How about a three-year revenue growth rate of 43.20%?

Despite all that is unknown, one thing is certain: Facebook will no longer be conducting its business as usual. Those who believe Facebook is currently undervalued might want to give pause and reassess their assumptions.

Disclosure: I have no positions in the stocks mentioned in this article.

This article originally appeared on gurufocus, the value investing site.

About the author:

John Kinsellagh

John Kinsellagh is a financial writer, former financial advisor and attorney, with over twenty-years experience in civil litigation and securities law. He completed the Boston Security Analysts Society course on Investment Analysis and Portfolio Management.

He has served as an arbitrator for FINRA for over 25 years resolving disputes within the financial services industry. He writes primarily on financial markets, legal and regulatory issues that impact the investment community, and personal finance.

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