This 'Capital Efficient' Tech Giant Is on Sale

Behind electricity and the germ theory of disease and its leading application (antibiotics), the Internet is the most powerful modern-day invention. And no other innovation in history created so much wealth so quickly...

Today, the 10 largest Internet companies – Amazon, Google, Facebook, Tencent, Alibaba, Baidu, Priceline, eBay, JD.com, and Expedia – have combined annual revenues of around $350 billion. The combined value of their stock is about $1.9 trillion.

Almost none of these businesses existed 25 years ago.

To understand the secret behind how the Internet works and why it generates so much wealth so quickly, you must know two things...

First, the Internet enables instant communication between a virtually unlimited number of people or computers ("nodes" in network-speak) on the same channel. And the second aspect of the Internet that investors must understand is called "Metcalfe's Law."

Metcalfe's Law isn't a technical algorithm. It doesn't describe anything about how the Internet functions or how it grows. It isn't about technology. It's about economics.

In short, thanks to his work with personal computers in the 1970s, entrepreneurial engineer Robert Metcalfe figured out that linking computers together would prove to be extremely valuable...

As he launched a company to develop and sell Ethernet equipment in 1980, Metcalfe gave lectures about computer networks and how they grow in value. He hypothesized that the value of a computer network would grow by the square of its nodes. Thus, a computer linked to a printer and three other computers wasn't just more useful in an arithmetic way (1+1+1+1+1=5)... It was geometrically more valuable (5x5=25), too.

These ideas haven't been proven in any systematic way, but plenty of real-world evidence shows the "network effect" is real... As the Internet emerged in the mid-1990s, several companies quickly took advantage of these dynamics. And one particular network has showed the awesome power of Metcalfe's Law with even greater efficiency than any others.

This new computer network was commercialized in the last decade. But it's already worth more than $300 billion – making it the largest, fastest accumulation of wealth in history.

By July 2010, just six years after its launch, Facebook (Nasdaq: FB) had more than 500 million users. It reached the 1 billion user mark in 2012, just eight years after its launch. The company's initial public offering ("IPO") in the same year valued Facebook at $100 billion – the largest IPO valuation in history. And it has continued to grow from there...

Yet many investors still don't understand the network effect. They don't understand that Facebook's size is what makes it so valuable. And they don't understand how that value is going to continue to grow rapidly for a long, long time.

Today, Facebook operates the largest social media network on the planet...

It has 2.3 billion monthly active users across the globe. Instagram, which Facebook bought for the comically low price of $1 billion in 2012, has roughly another 1 billion users. As you're probably aware, these social media platforms are free to use.

Rather than charging subscription fees, Facebook monetizes its immense networks by selling advertising. Facebook and Alphabet (GOOGL) – the parent company of Internet-search giant Google – command nearly two-thirds of the digital advertising market.

Facebook has a fabulous business model... It's digital, highly scalable, and capital-efficient... And if you take a close look at its financials, you'll see just how special Facebook really is.

Facebook has about $55 billion in annual revenue – roughly five times the median for companies in the S&P 500... But despite being much larger than most companies, Facebook is still growing like it's a small cap. Its revenue growth was an astounding 42% in the past four quarters (year-over-year). The median growth rate for companies in the S&P 500 is just 9%.

Facebook also has wide margins... Despite spending about $9 billion on research and development over the past 12 months, the company doesn't have significant operating expenses. Facebook's operating margin (operating income as a percentage of revenues) was 47% over the past year. That's about three times as wide as other companies in the S&P 500.

Facebook doesn't have significant capital requirements, either. It doesn't need to build and maintain factories... And the computer servers and network infrastructure that Facebook must buy aren't as costly as heavy machinery.

As a result, the company has tremendous free cash flow ("FCF"), which is what's left over after all operating expenses and capital expenditures. Facebook's FCF margin (FCF as a percentage of revenue) was 34% over the past year. Again, that's several times greater than a typical company's FCF margin.

The median ratio of total debt to assets for S&P 500 companies is 30%... But with ample FCF, Facebook's balance sheet is pristine, with zero debt and around $40 billion of cash.

Facebook's market cap is around $420 billion. With no debt and its cash hoard, Facebook's total firm value – or enterprise value ("EV") – is about $380 billion.

We know Facebook is anything but ordinary. But its valuation would suggest otherwise...

To assess Facebook's valuation, we can compare its EV with earnings before interest, taxes, depreciation, and amortization ("EBITDA"). That's the earnings available to all stakeholders of the company.

Facebook's EV/EBITDA multiple is 13.4. That's nearly the cheapest valuation that Facebook has traded at since going public in 2012.

Meanwhile, the median EV/EBITDA in the S&P 500 is 12.4. So Facebook is only trading at a slight valuation premium to that of the market... which is absurd.

Facebook deserves a much, much higher valuation multiple than the median large cap. But two recent shocks have caused Facebook's share price to suffer...

First, in March 2018, the New York Times broke a startling story.

Cambridge Analytica – a U.K.-based political-consulting firm – had obtained private information about tens of millions of Facebook users... And it had used these data as it worked on Donald Trump's 2016 presidential campaign.

Facebook routinely allows data to be harvested by researchers for academic purposes... But Cambridge Analytica shouldn't have been able to purchase it. That was a violation of Facebook's rules.

The incident raised concern about personal-data privacy. Facebook and its executives came under fire. Facebook CEO Mark Zuckerberg even testified before Congress.

Unsurprisingly, Facebook's share price dipped. Prior to the story being published, the stock was trading around $185 a share. It bottomed in late March and early April around $150 a share.

Facebook's share price recovered and reached a fresh all-time closing high of $217.50 this past summer. Then came the second big shock...

On July 25, 2018, Facebook reported second-quarter 2018 results. The company reported revenue of $13.7 billion for the quarter, falling short of Wall Street's average estimate of $13.8 billion. On the conference call, management estimated that its operating margins would shrink to the mid-30% range over time.

The market's reaction was harsh and unforgiving. Facebook's stock plunged 19% in a day.

Keep in mind that Facebook still grew its revenues by 42% year-over-year. Most companies would kill for that type of growth.

Analysts and investors seem to have forgotten that it would be impossible for Facebook to grow at a 40% rate forever (or else Facebook's sales would grow to be larger than the U.S. economy before long).

Facebook's downshift in growth is nothing to fear. It was inevitable. We believe the company can still achieve 25% year-over-year revenue growth in 2019. That's more than double the growth rate of most large-cap companies out there.

Plus, even if Facebook's operating margins shrink to 35%, that would still be more than twice as wide as those of most large companies. Furthermore, the company will remain capital-efficient. It will still convert a high percentage of its revenues to FCF.

Nonetheless, the market panicked after the quarterly announcement...

With the broader stock market growing volatile in October and tech stocks taking it on the chin, Facebook has continued to struggle. The stock slid through the rest of 2018, bottoming at less than $125 a share in the final two weeks of the year.

Since then, Facebook is up almost 20% to around $147 a share. But that's still more than 40% below the stock's all-time high last summer, potentially giving investors an attractive entry point today.

Sometimes investing is simple.