The user data concerns that spooked Facebook (NASDAQ:FB) investors earlier this year seem all but forgotten now. The social network’s stock is up 14% since news broke in March about a third party that mishandled user data. Year to date, Facebook stock is up 11% — and that’s on top of a 53% gain in 2017.
Investors are optimistic about Facebook’s future, to say the least.
But has Facebook’s valuation gotten out of hand? The answer may surprise you.
Valuing Facebook stock
Though Facebook may be a high-tech company, there’s no need to stray from traditional valuation methods when analyzing the stock’s current valuation and when estimating what it actually might be worth. In fact, thanks to the company’s strong earnings and free cash flow, traditional valuation metrics such as price-to-free cash flow and price-to-earnings provide investors useful insight into how the market is thinking about Facebook’s growth potential.
Price-to-free cash flow ratio
A quick glance at these metrics makes it clear that investors expect similar growth over the long haul from both Facebook and Alphabet. However, a look at each company’s recent earnings growth shows two very different trajectories.
Facebook’s EPS is rising much faster than Alphabet’s. For instance, in Facebook’s first quarter of 2018, EPS soared 63% year over year. In the same period, Alphabet’s EPS increased 28% year over year when excluding a benefit in the company’s first quarter of 2018 related to a new accounting standard. Facebook’s operating income has similarly been growing much faster, rising 64% year over year in Q1, while Alphabet’s was up only 7%.
So, what’s the catch? Why aren’t investors rewarding Facebook with a higher premium than Alphabet if the company is clearly growing faster? One possible explanation is because Facebook expects an enormous jump in operating expenses in 2018. As Facebook ramps up its investments in safety and security, content, and long-term growth initiatives, management expects operating expenses to climb between 50% and 60% this year — a level that could surpass Facebook’s revenue growth since its revenue is growing at a slower rate. In the trailing 12 months, Facebook’s revenue increased 49.7% year over year.
Buy, sell, or hold?
Still, Facebook’s valuation is arguably conservative considering the company’s strong growth recently and given its excellent track record of product innovation and execution. Furthermore, Facebook’s plans to spend big on two important areas — content acquisition and long-term initiatives — could ultimately help the company reinforce its competitive position and grow revenue and earnings over the long haul.
It’s also worth noting that since Facebook’s earnings per share have been rising faster than its stock price, the company’s price-to-earnings ratio has actually been falling. Just two years ago Facebook’s price-to-earnings ratio was well above 50 — far higher than its P/E of 29 today.
Overall, Facebook’s valuation appears conservative relative to its recent growth and its longer-term prospects. But I’m still going to call the stock a hold at $194, as investors should look for a greater margin of safety before they buy. Facebook stock would look more like a buy below $175. However, it certainly doesn’t look like a sell.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Daniel Sparks has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), and Facebook. The Motley Fool has a disclosure policy.