- August 8, 2022
- Posted by: Ramkumar
- Category: Posts
Revisiting Meta Platforms Valuation
I value social media companies regularly to see if the network effects that we thought would work for these firms continue to operate. Meta and Google are the two leaders in social media networks that have disrupted the traditional advertising model. They were instrumental in firms reallocating their advertising spending from traditional to digital. Though the global advertising market grows in single digits, more ad spend gets driven to digital channels. Meta and Alphabet, with their platforms, capture the majority of this advertising spend. Apart from Meta and Alphabet, Twitter and Snap are the other platforms that drive a majority of their revenues from advertising. Unfortunately, Twitter has difficulties monetizing revenues from its users. With Musk’s claim that most of these accounts are spam, Twitter’s only hope is to force Musk to buy them through legal recourse and save themselves from further misery. On the other end, Snap is 90% down from its 2021 income and, with operating losses, is a laggard and does not pose serious competition to Meta and Alphabet.
Meta Platform Is A Cash Cow
As Meta and Alphabet are the leaders in advertising, the only challenge is the continued growth in the digital advertising market. However, in the last few years, the growth has stagnated, and it has become imperative for Meta platforms to identify new avenues for growth to improve shareholder value. To achieve this, Facebook changed its name to Meta platforms to position itself as a leader in Metaverse – an all-encompassing but loosely defined digital environment. On the other end, Alphabet is working on its “other bets” from cloud to EV to identify new growth areas and pivot from digital advertising.
Alphabet and Meta have failed to reach new growth areas, mounting significant operating losses in their growth avenues. As demand from advertising slows down and Meta/Alphabet cannot pivot away from advertising, investors are concerned about its value creation and whether they demand a higher multiple to justify their price.
As fears of recession increase with rising inflation and subsequent hike in interest rates, the demand for advertising has declined, reflecting an impact on Meta’s revenues this quarter.
Advertising contributes 98% of Meta’s revenues, and new growth areas like Reality Labs have not shown any significant growth potential.
As advertising spending declines, Meta’s EBIT has come under pressure.
I valued Meta earlier this year; since then, the prices have corrected significantly.
In my view, the valuation drivers for Meta are:
- Growth in Advertising Revenues
- Probability of Growth in Non-Advertising Revenues
- Operating Margin from Non-Advertising Revenues
- Sales/Invested Capital for the Non-Advertising segment
I assume that the growth in advertising will taper to 10% in the next five years and then converge towards the global GDP growth.
I assume the target operating margin for Meta will settle at 33% as it will continue to burn cash in the hope of identifying its next growth driver in VR/Metaverse.
The CAPEX investments should improve as these investments will turn to Sales, effectively improving the Capital turnover ratio from 0.8 in the next five years to 1.25 in a stable phase.
I assume Meta’s WACC is at 7.8%, taking its capital structure and business risk will remain broadly stable.
Taking the above inputs, I value Meta Platforms at $292/share, making it vastly undervalued to its current stock price of $167.
As there is a divergence between market price and intrinsic value, I decided to validate my value drivers and how much Meta’s valuation depends on its value drivers.
When I determine the co-efficient of determination between Equity value and Meta’s value drivers, I find that valuation depends on its EBIT and Revenues.
Thus, there is a higher probability that my revenue growth and target EBIT inputs can go wrong, impacting Meta’s valuation. To overcome this, I did a Monte Carlo simulation to determine what percentile my valuation of Meta lies.
The following are the inputs from the Monte Carlo simulation:
The mean price = $264.37
Median at 50th percentile = $257
At 25th percentile = $231
At 5th percentile = $194
The above simulation shows that the markets have undervalued Meta considerably, and Meta’s price is less than five percentile.
Reason For Meta’s Undervaluation
The markets have assumed that revenues from Meta will stagnate and decline while it will not succeed in converting any of its new growth initiatives to the next growth driver. Further, the investors think that Meta has lost its network effects, and thus, its margins will decline and converge towards the industry average.
The markets treat Meta as a conglomerate and have assigned a conglomerate discount. Therefore, in my view, markets are very harsh towards Meta.
Meta can do share buybacks to signal that markets have not understood its growth strategy. Meta is already doing share buybacks, but its share price declines have not stopped. I think a prudent way is to spin off the Metaverse business from the advertising business so that investors can understand where is the value generation happening. Meta can also unlock value from the spin-off, improving its valuations.