Facebook stock is soaring. Up more than 100% over the past twelve months, shares have finally eclipsed the IPO price of $38. Given the company's mobile dominance and revitalized growth, a rise is certainly justified. But has euphoria taken the stock too far?
A DCF valuation
A discounted cash flow, or DCF, valuation may not be perfect enough to serve as the sole basis for decision-making, but it's a great starting point to give investors some context. Let's see how Facebook measures up.
In the trailing 12 months, Facebook generated $2 billion in free cash flow, or FCF. To estimate the value of Facebook stock using DCF, we'll need to come up with some growth rate for Facebook's free cash flow going forward.
Facebook's revenue in the company's most recent quarter grew by 53%. We could use a growth rate close to 53% as a starting point for Facebook's FCF growth, going forward, but that would be far too rosy a future. In a DCF valuation, conservatism is key.
Let's assume Facebook's FCF grows next year more closely in line with the company's year-over-year average growth rate for the trailing four quarters: 41%. Then we'll assume that as the company grows it faces less and less growth opportunities. In turn, FCF growth will decelerate by about 15% per year.
This scenario would look something like this:
FCF Growth Rate
Given these assumptions, a DCF valuation yields a fair value for Facebook shares of about $49. Though $49 is higher than the stock's value today, it doesn't mean the stock is a buy. Investors should require a decent margin of safety from their fair value estimate -- at least 25% for a high-growth company like Facebook, since it's hard to know how quickly the company's high growth rates will decelerate in the future. Today, Facebook shares trade at about a 15% discount to $49.
In other words, our discounted cash flow valuation says the stock is a hold, but not a buy.
Comparing Facebook to Google
Facebook trades at 15.8 times sales. That's a large premium over Google's 5.1 times sales. The same is true when you look forward to next year's earnings. Facebook trades at 46.9 next year's earnings estimates, more than 2.5 times Google's forward P/E of 18.
Sure, Facebook is growing faster. Second-quarter revenue was up 53% from the year-ago quarter compared to Google's 20% increase in advertising revenue during the same period. But does Facebook really deserve to trade at a premium three times that of Google's?
How to think about Facebook stock
So a DCF valuation says Facebook is a hold and a comparison to Google proves Facebook is expensive. What does all this mean for investors?
It simply means that Facebook is not a bargain. So I wouldn't plan on loading up on the stock to the point that it amounts to a significant portion of my portfolio.
At the same time, there's no denying that Zuckerberg & Co. are firing on all cylinders. Even more, as I've explained before, the company's success in mobile combined with its powerful network effect together give Facebook enduring characteristics that might make the stock worth adding to your portfolio even if it is a hold -- albeit as a smaller holding.
If the stock was clearly a sell by DCF valuation standards, I would probably avoid the stock entirely. But given Facebook's enduring characteristics, I wouldn't let fairly valued shares cause me to shun the stock entirely.
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The article Facebook Stock Is Soaring. Is It Still a Buy? originally appeared on Fool.com.
Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Facebook and Google. The Motley Fool owns shares of Facebook and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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