Facebook (NASDAQ:FB) reported excellent third-quarter results on Oct. 29. Facebook produced higher free cash flow (FCF) and revenue in the quarter ended September 30; therefore the outlook for FB stock is higher as well.
The company made 22% more revenue year over year for the same quarter. In fact, Q3 revenue was 5.1% above Q2 2020 revenue, almost all of which came from advertising.
Moreover, the company’s ARPU (average revenue per user) rose 8.8% worldwide year-over-year. In addition, the ARPU grew 11.9% from the previous quarter. So clearly the company is on a growth path.
FCF Is High and Growing
Facebook says its FCF grew from $5.631 billion last year during Q3 to $5.95 billion, or 5.67%.
However, keep in mind that the company uses a slightly different definition of FCF than others for this non-GAAP measure. They include a deduction for principal payments on finance leases. This is non-standard but is growing in acceptance among larger companies.
Finance leases are assets purchased by a company but paid over time with a lease payment, as well as a principal paydown, often in bullet form. I suppose Facebook feels that principal finance lease payments should be deducted in the FCF definition. This makes it just like capex, since they both have to be paid in order for assets to produce cash flow.
Using this definition, the FCF grew by an astounding magnitude over Q2. For example, last quarter FCF was only $514 million. This quarter, FCF grew to $5.95 billion, or 11.6 times the prior quarter.
In fact, using this definition, we can assume that FCF will explode over the next year. Revenue in Q3 was $21.47 billion, so the FCF margin was 27.7%. Since analysts expect revenue will hit $103.63 billion by the end of 2021, using the same margin estimates 2021 FCF at $28.7 billion.
Facebook’s Valuation Upside
That $29 billion represents 3.6% of Facebook’s market capitalization of $794 billion. This is much higher than its traditional FCF yield.
I previously argued that Facebook’s valuation should be higher due to its FCF margins. I wrote it should have a similar FCF yield as Alphabet (NASDAQ:GOOG, NASDAQ:GOOGL), at 3.1%, since it has similar FCF margins.
Therefore, taking the forecast FCF next year of $28.7 billion and dividing it by 3.1%, one derives a value of $925.8 billion. This represents a potential 16.6% gain over its present $794 billion market value.
As a result, FV stock is worth at least $317.28 per share.
What Analysts Say About FB Stock
Analysts surveyed by Yahoo! Finance estimate earnings per share (EPS) will rise from $9.31 this year to $10.40 in 2021. That puts FB stock on a forward price-to-earnings (P/E) ratio of 29 times this year, falling to 26.1 times next year.
This is important since Morningstar reports the company had an average P/E ratio of 41 times over the past five years. Therefore, using the 2021 EPS forecast, FB stock should eventually trade at $426.40 per share (i.e., $10.40 times 41 multiple). This assumes that the “reversion to the mean” theory of stock valuation works out over time.
So now we have two methods of valuing FB stock. Using FCF, we get $317.28 and using forward P/E, we get $426.40. The average of these two target prices is $371.84, or 36.65% above today’s price.
Analysts on Wall Street’s sell-side have similar targets to my first estimate above. Yahoo! Finance says that 47 analysts have an average target of $314, whereas Marketbeat.com says the average of 46 analysts is $295.19. However, TipRanks.com says 35 analysts who have written up FB stock in the last months have an average target of $322.73. The average of $310.64 per share is 14% above today’s price.
My estimate of $371.84 is higher than all of these forecast prices, but sell-side analysts tend to stick to a similar range. They like to avoid “tall poppy syndrome,” where the tallest flower gets mowed down.
What To Do With FB Stock
Since Facebook reported Q3 earnings, FB stock has risen 3.4% as of Tuesday, Nov. 10, though it was falling over the preceding several days. This is foreshadowing for the future.
Facebook’s FCF is so powerful the market simply won’t be able to avoid recognizing its huge growth. Facebook has $55.6 billion in cash and securities right now. If my projections about its FCF pan out, by 2021 that pile will grow by $28.7 billion.
Therefore, unless it spends down the FCF generated on an acquisition or buybacks, Facebook’s cash pile will grow by 51.6% by the end of 2021. That alone could raise the value of the stock by 10%.
Why? At $80.3 billion (i.e., $55.6 billion added to $28.7 billion) cash and securities will equal 10.1% of its $794 billion market cap. Therefore, look for FB stock to move up 15% to 36% over the next year as the market begins to appreciate its free cash flow.
On the date of publication, Mark R. Hake did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.