After all, one of the biggest knocks on Facebook entering 2016 was its nosebleed stock price of about 100-times trailing 12-month earnings. But on the heels of Facebook's impressive second results, investors should be increasingly confident the company can end the year at a multiple below Silicon Valley stalwarts like
How so? When young companies like Facebook hit public markets their earnings are normally obscured by titanic stock compensation: Restricted share units that were handed out with the carrot of an eventual IPO are triggered, and management begins to use public stock as a currency to attract talent. The result? Often the lions share of employee pay is tilted towards stock units, options and non-cash performance-based awards.
For instance, in Facebook's first four years on public stock markets it paid out roughly $7.3 billion in share-based compensation, a titanic figure if one were to remember that the company's May 2012 initial public offering raised $16 billion. At Facebook's IPO valuation of $104 billion, nearly 7% of its IPO market value was paid out in stock awards in under four years. Furthermore, in 2015, stock pay was equal to 17% of Facebook's revenues, and 50% of operating income.
Put differently, any investor scared away by Facebook's price-to-earnings ratio of about 100 in 2015 was being driven away in large part by the company's stock pay, which exceeded $3 billion for the year.
However, if trends from the first half of 2016 continue the issue will fall away as an overhang for fundamental investors who do care about profitability and GAAP earnings.
Take Facebook's second quarter. Of course the big story is how Mark Zuckerberg, Sheryl Sandberg and the company's rank and file drove 59% growth on the top-line for a social network that's already being used by well over a sixth of the human population. But what about Facebook's more than tripling of GAAP net income and earnings per share?
The social network generated $2 billion in profits, or 71-cents a share in earnings. If those earnings just held steady for four quarters and Facebook's stock remained flat at $125, its beginning of year P/E multiple would fall more than half to under 50.
Using estimates from RBC Capital's Mark Mahaney $3.02 in GAAP EPS in 2016, Facebook's P/E at a $125 stock price would fall to 41-times earnings, far less than Adobe's current multiple. Mahaney's estimate of $4.32 in GAAP EPS in 2017 puts Facebook at a current multiple not far off the P/E's investors currently give Alphabet and Microsoft.
What is the cause of this rising profitability?
A major piece of the equation is a slowing in the growth of Facebook's stock pay, which rose just 6% in the second quarter as revenues surged 59%. As a consequence, Facebook's stock pay as a percentage of revenues fell to 12.8%, and there is a chance the figure may fall as low as 10% by year-end. RBC's Mahaney currently estimates $3.3 billion in stock pay versus $11.7 billion in operating profits and $27.3 billion in total sales.
If Facebook can keep its stock spigot in check, it has a real chance of entering 2017 at a valuation that doesn't scare investors. And when it comes to a dorm room sensation growing into blue chip stock market status - as Facebook has - it is one of the most important things for CEO Zuckerberg and his board to keep control over.
