Krause Fund Research Technology (Alpha) · 2016-06-21 · Spring 2016 F Facebook, Inc. (NASDAQ: FB) Recommendation: NO ACTION Current Price: $110.45 April 19, 2016 . Important disclaimer

Important disclaimer appears on the last page of this report

1

Analysts

Jacob Molina

[email protected]

Mingjian Li

[email protected]

Company Overview

Facebook, Inc. (NASDAQ: FB) builds useful and engaging

products that enable people to connect and share through

mobile devices and personal computers. They also help

people discover and learn about what is going on in the world

around them, enable people to share their opinions, ideas,

photos and videos, and other activities with audiences

ranging from their closest friends to the public at large, and

stay connected everywhere by accessing their products,

including Facebook, Instagram, Messenger, WhatsApp, and

Oculus.

Stock Performance Highlights 52 week High $117.59

52 week Low $72.00

Beta Value 0.972

Average Daily Volume 35.65 m

Share Highlights Market Capitalization $323.99 b

Shares Outstanding 2.83 b

Book Value per share $15.60

EPS 2015 $1.31

P/E Ratio ttm 84.31

Dividend Yield N/A

Dividend Payout Ratio N/A

Company Performance Highlights ROA 7.46%

ROE 8.34%

Total Revenues $12.47 b

Financial Ratios Current Ratio 11.25

Quick Ratio 10.91

Debt to Equity 10.50%

Profit Margin Ratio 20.57%

Gross Margin Ratio 84.01%

Facebook: Too Early to Tell

Facebook has the largest user base among all social media

companies. On average, 8 out of 10 American adults use

Facebook every month. A leading position helps Facebook gain

more investments and generate revenues from companies looking

to advertise than any other social media company.

Social media is a new and highly competitive industry and

Facebook is facing challenges from other new social media

companies. For example, younger people tend to use Snapchat

more often than Facebook, which takes away users from

Facebook’s user base. If Facebook cannot launch new, innovative

products to attract younger users, Facebook will lose potential

future revenues.

Facebook has seen 30% growth for its revenue and net

income since 2012. Companies have been beginning to utilize

social media networks as a tool to do advertise on. Facebook has

benefitted from this and, as a result, in spring 2016, the stock price

of Facebook beat the expectations and increased by 15%.

However, high returns mean high risks. No companies can

maintain a 10 % growth rate forever, let alone 30%. The total

potential user base within the US has become saturated. We are

not sure whether Facebook can experience huge growth outside

of the US. If they do not meet the expectations of their

stockholders, their stock price will decrease.

One Year Stock Performance

Source: Yahoo! Finance (Blue = FB, Red = S&P 500)

Technology (Alpha) Krause Fund Research

Spring 2016

F

Facebook, Inc. (NASDAQ: FB)

Recommendation: NO ACTION Current Price: $110.45

Target Price: $60.92

April 19, 2016


2

EXECUTIVE SUMMARY

We do not recommend investing in Facebook because we believe

that once Facebook transitions from its growth phase to its

maturity phase, the stock price will start to decrease due to the

company not being able to meet stockholders’ expectations of

growth rates and overall levels of net income. Although Facebook

has seen tremendous growth over the past few years in terms of

its user base, revenues, and net income, we believe it is

unreasonable to assume that Facebook will be able to maintain

these levels for more than a few years.

Source: Facebook 10k

ECONOMIC OUTLOOK

Real Gross Domestic Product (GDP)

The real gross domestic product is the inflation adjusted value of

all goods and services produced within our economy during a

given time period. GDP is often used as an economic indicator

for the overall health of the economy. One method of

calculating GDP is by using the expenditure method which is

calculated by the sum of four main factors which are: private

consumption, private investment, government spending, and net

exports. Since a large portion of GDP is calculated based upon

private investments and consumption, GDP can be related to

other economic factors such as Consumer Confidence Interval

(CCI) and Unemployment Rate.

Future growth rates of GDP can help us to predict the growth in

Facebook’s revenues numbers. With a 1.4% growth of real GDP

in the fourth quarter of 2015 and a forecasted growth of GDP

being between 2% and 3% in the coming years, we can predict

that Facebook’s sales, in the U.S. will also increase. This

relationship can be derived from the increased consumer

spending and confidence in the economy. The following chart

shows the change in U.S. real GDP in the last ten years.

Historically, you can see that real GDP growth remains between

2% and 3%, except during a recession such as in 2008.

Source: Bloomberg Business (Updated 2/26/16)

Unemployment Rate

The U.S. national unemployment rate is calculated by The

Bureau of Labor Statistics (BLS) and is done by surveying

60,000 households across the country. After data is collected

from this sample population, the unemployment rate is

calculated by dividing the number of people who are gainfully

employed by the number of people who are out of a job, but who

are actively looking. People who claim to be out of a job and not

actively looking are not accounted for in the calculation of the

national unemployment rate.

Consumer confidence is inversely related to the national

unemployment rate because when consumers see an increasing

unemployment rate, they fear a potential economic turmoil may

be near. The current unemployment rate in the U.S. is 5% and

as you can see from the chart below, the unemployment rate has

been steadily decreasing for the past five years. This is

important to Facebook, because as more consumers are

employed the amount of disposable income consumers are

willing to spend on products such as Facebook’s new virtual

reality headset, the Oculus Rift.

Source: Bloomberg Business

Inflation Rate

The inflation rate in the U.S. is calculated by tracking the

changes in the Consumer Price Index (CPI). CPI and Producer

Price Index (PPI) are closely related to one another. For

example, PPI in the technology sector has been steadily

decreasing since 1990 due to what we believe are improved

608854

10561228

13931564

17791971

2162

0

500

1000

1500

2000

2500

2010 2011 2012 2013 2014 2015 2016E

2017E

2018E

Users of Facebook (In millions)

The users of Facebook (In millions)

Linear (The users of Facebook (In millions))


3

technologies for producing IT hardware. This idea is related to

Moore’s Law which states that the number of transistors on a

circuit double roughly every two years and because of this keep

technology costs down.

Due to the decrease in PPI, the CPI in the technology sector has

also been decreasing because of decreased production costs and

an increased supply of hardware and software in the market.

Within the last five years, the overall inflation rate has been

pretty low, in between 0% and 2% with it being less than 1% the

last three. This trend is illustrated in the graph below.

Source: usinflationratecalculator.com

Foreign Exchange Rates

The foreign exchange rate represents the value of one currency

against that of another. The value of the US dollar is crucial to

many countries and international companies. Companies, like

Facebook, that operate overseas have to keep a close eye on the

exchange rates to avoid losses in their profits.

The US Dollar Index compares the US Dollar to a basket of six

other currencies. The US Dollar Index started at 100 basis

points in 1970 and anything below that would imply that the

value of the dollar has decreased. This index is currently juts

below 95 which means the dollar is still relatively pretty strong

as it has only decreased roughly 5% in forty years. Below is the

historical chart for the US Dollar Index which shows a fairly

strong dollar for the past two years.

Source: Bloomberg Business

Consumer Confidence Interval (CCI)

The Consumer Confidence Interval (CCI) is a measure of

consumer’s optimism on the health of the economy. A high CCI

means that consumers are very optimistic about the current and

potential future of the economy, which has the potential to lead

to increased spending of discretionary income in the economy.

As you can see from the graph below, CCI has been on the rise

for the past five years.

We believe that when there is a higher CCI, companies in the

Technology sector will be more profitable due to increased

disposable income for consumers to spend their money on

products. In addition, with personal income levels increasing

around an annual rate of 0.4% we can expect all sector to benefit

due to increased money for consumers to use at their discretion.

In the future, we predict CCI to continue to increase at a constant

rate of around 2% over the next couple of years.

Source: tradingeconomics.com

INTERNET SOFTWARE & SERVICES

INDUSTRY ANALYSIS

Industry Description

Facebook operates within the Technology sector of the overall

economy but more specifically, the Internet Software & Services

Industry, which contains companies that provide Internet

services, including personal and business access to the Internet.

The current product lines for the Internet Software & Services

Industry include online searching, social media, online

communication, and mobile apps.

The main companies for this industry include Alphabet

(Google), Facebook, Yahoo!, and others.


4

Source: 10K

The business segments within the Internet Software & Services

Industry include advertising, searching, and social media. We

believe that mobile advertising will likely grow and overtake

search as the largest category of online revenues within the

industry as we continue to see growth in the number of people

using mobile apps.

In terms of revenue streams, advertising continues to be the most

important source of revenue for companies within the Internet

Software & Services Industry. For example, digital advertising

currently contributes over 89% of Alphabet's revenues, over

92% of Facebook's revenues, and 81% of Yahoo!'s revenues

(Kessler).

Source: 10 k

However, we believe that the growth rate in advertising revenue

for the companies within this industry will decrease over time

due to increasing competition within the market and the

inevitable decrease in growth rates as companies' revenues

continue to increase. Other sources of revenue for companies

within this industry can include license revenues, service

revenues, and subscriber revenues, but they are very marginal

compared to advertising revenues.

New initiatives within the Internet Software & Services include

pushes for mobile advertising, as it is becoming one of the most

important sources of revenues for companies as mobile apps

continue to increase in popularity and more and more people

gain access to smartphones.

Source: Statista

We also believe that companies within the industry will begin to

look overseas to expand their business due to oversaturation in

the US Market and Asian markets beginning to ripen with

opportunities for expansion. For example, we believe that the

Chinese government will eventually lift its bans on companies

like Facebook and Alphabet and allow them to operate within its

market and expand their user bases.

Recent Developments and Industry Trends Companies within the Internet Software & Services Industry are

starting to move towards mobile advertising as it has been

making up more and more of total Internet advertising revenues

over time.

67390

17079

41734557

2218 1048 1000 1300

Industry Market Sales (in Millions)

Alphabet Facebook Yahoo Microsoft

Twitter LinkedIn eBay Other

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Facebook Alphabet Yahoo!

Make Up of Industry Leaders' Revenues

Advertising Other Revenue

1435.71593.3

1859.32082.7

2292.52480.4

2659.4

0

500

1000

1500

2000

2500

3000

2013 2014 2015 2016E 2017E 2018E 2019E

Number of Smartphone Users Worldwide (in Millions)

Users

39%

23%

17%

6%

6%4%

3% 2%

Advertising Revenue 2014

Search Mobile Formats Banner

Digital Video Classifieds Rich Media

Sponsorship Other


5

Source: IAB Internet Advertising Revenue Report

Last year, mobile advertising made up a third of Internet

advertising revenues for companies within the industry (Kessler)

and we believe that this number will only continue to grow as

mobile apps have been becoming more popular with consumers

and access to smartphones has been increasing around the world.

Companies within the Internet Software & Services Industry

have increasingly been buying back shares and have

participating in more merging & acquisitions in the past few

years. We believe that these companies will continue to invest in

their own shares since their shares are becoming more and more

valuable and will also continue to participate in mergers &

acquisitions as it is a way to literally buy up competition and

give their company a competitive advantage.

Source: NetAdvantage

Recently passed Net Neutrality Laws will more than likely

enable and support continued innovation and competition within

the industry (Kessler). Net Neutrality is intended to level the

playing field within the industry and offer the same opportunities

to start-up companies and larger companies. One expected

outcome of Net Neutrality Laws are that advertising prices will

increase, which will be a disadvantage for smaller advertising

companies (Cordray). We are unsure as to whether or not the

law will have its desired effects because, in terms of technology,

people tend to stick to what they are familiar and comfortable

with rather than branch out and try something completely knew.

So only time will tell.

Some companies within the industry, such as Google and

Facebook, are trying to expand into markets overseas, especially

in Asian markets. We believe this strategy will help those

companies increase revenue and net income more since the

market of North America, the primary market of the industry, is

already saturated. For example, the increasing numbers of

Facebook users in North America is 13 million while the

increasing numbers of users in Asia is 90 million.

Source: 10k

In addition, the CEO of different companies have expressed how

important the Asian market is to them. For example, recently the

chairman for Alphabet came out and said that they have plans to

expand back into China and that the company has been in

constant contact with Chinese companies and officials, which

will help to make these plans a reality (BBC). We believe that

we will see a continued increase in users in Asia since the

market in the US has become so saturated with Internet Software

& Services companies.

37%

30%

14%

7%

5%

2% 1% 4%

Advertising Revenue 2015

Search Mobile Formats Banner

Digital Video Classifieds Rich Media

Sponsorship Other

017.2

39.2 49.7

83.5102.5 112.7

0

63.5 68.598.7

152.5

274.5295.4

0

50

100

150

200

250

300

350

2009 2010 2011 2012 2013 2014 2015

Return on Internet Software & Services Industry and S&P 500

S&P 500 Internet Software & Services

193 201 208 219

0

50

100

150

200

250

2012 2013 2014 2015

Monthly Active Users in US & Canada (in Millions)

Monthly Active Users in US & Canada

Linear (Monthly Active Users in US & Canada)

298368

469540

0

100

200

300

400

500

600

2012 2013 2014 2015

Monthly Active Users in Asia (in Millions)

Monthly Active Users in Asia (in Millions)

Linear (Monthly Active Users in Asia (in Millions))


6

Markets and Competition The current competitive climate for the Internet Software &

Services Industry is seen as one of the world's most dynamic and

competitive environments (Kessler). Within the industry, it can

be observed that the larger companies often dominate certain key

areas – with Alphabet dominating the Searching business

segment and Facebook dominating the Social Media business

segment (Kessler). These larger companies dominate these

business segments because they start business early so that their

brand is more widely recognized within the segment, their user

bases are larger, they control a captive audience, they have a

more diversified and successful business model, and also have

greater financial flexibility to implement many different

strategies due to large amounts of market capital.

The major players within the Internet Software & Services

Industry are Alphabet and Facebook who make up 83.5% of the

entire industry's total revenue.

Source: 10K

The competitive forces that shape the Internet Software &

Services Industry are industry rivalry, new entrants, threat of

substitutes, and consumers. In terms of industry rivalry, there is

substantial competition for online ads spaces. . In terms of new

entrants, it tends to take more time for newer companies to

thrive within the industry. Usually, these companies need more

money as early investments. However, once new companies

enter the market, they can make a profit if they are able to create

their own recognizable brand and find a way to differentiate

themselves from their competitors. In terms of threat of

substitutes, it isn't as large of a force that is shaping the industry

due to familiarity and trust issues for consumers (Kessler).

Switching over to different software and services offers a larger

challenge to consumers due to these factors. Therefore, we

believe that Facebook will be able to stay in a monopoly position

for Social Media for the next few years.

However, we also find that teenagers could also start to use other

applications besides Facebook. For instance, Snapchat is a

company that was able to quickly become part of the industry

and become very popular amongst teenagers and as a result, their

user base has been continously growing.

Source: Business Insider

If other companies have similar success like Snapchat and attract

other users, Facebook could face challenges in retaining its

current user base. In terms of consumers, Facebook has over 1.6

billion users in its user base and has been seen continuous

growth since 2003.

Source: Facebook 10k

However, teenage consumers seem to be more drawn to newer

apps, such as Snapchat and Instagram. Therefore, the future of

companies within the industry will depend on whether or not

they are able to retain and attract younger users to their products.

The best positioned firms within the industry are Alphabet and

Facebook. These larger firms are best positioned because their

brand is more widely recognized, their user bases are larger than

their competitors, they have more diversified and successful

business models, and they have greater financial flexibility due

to larger amounts of capital.

The leaders within the industry are Alphabet and Facebook

while the followers are Yahoo!, Twitter, LinkedIn, and other

companies.

67390

17079

4173

45572218 1048 2300

Industry Market Sales (in Millions)

Alphabet Facebook Yahoo! Microsoft

Twitter LinkedIn Other

0% 20% 40% 60% 80% 100%

Snapchat

Instagram

Twitter

Facebook

Demographic of User Bases for Top Social Media Companies

(in Years of Age)

18-24 25-34 35-44 45-54 55-64 65+

1 6 12 58145

360

608

854

1056

1228

1393

1591

0

200

400

600

800

1000

1200

1400

1600

1800

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Facebook Users (in Millions)

Total Facebook Users (in Millions)


7

Table Comparing Leading Competitors: GOOG YHOO FB TWTR LNKD Industry

Market

Cap:

466.93

B

25.46B 284.1

2B

9.95B 13.49B 231.42M

Employees

:

61,814 10,700 12,69

1

4,200 N/A 387

Qtrly Rev

Growth

0.18 0.02 0.52 0.58 0.34 0.2

Rev. (ttm): 74.99B 4.97B 17.93

B

2.22B 2.99B 129.16M

Rev.

within

USA

34.8B

3.98B 8.51B 1.44B 1.85B N/A

Rev.

outside

USA

40.1B

0.99B 9.415 0.78 B 1.14B N/A

Rev. with

the USA%

46.4% 80.1% 47.46

%

64.86% 61.87% N/A

Rev.

outside of

the USA

%

53.6% 19.9% 52.54%

35.14% 38.13% N/A

Gross

Margin

(ttm):

0.62 0.58 0.84 0.67 0.86 0.53

EBITDA

(ttm):

24.42B 474.68M

8.24B -208.40M

269.53M

3.88M

Oper.

Margin

(ttm):

0.26 -0.03 0.35 -0.24 -0.05 0.01

Net

Income

(ttm):

16.35B -4.36B 3.67B -

556.15M

-

166.14

M

N/A

EPS (ttm): 23.78 -4.64 1.29 -0.86 -1.29 N/A

P/E (ttm): 28.56 N/A 77.2 N/A N/A 29.72

PEG

(5 yr

expected):

1.18 -6.76 0.98 0.64 1.23 1

P/S (ttm): 6.26 5.14 15.84 5.07 4.84 3.25

User base 1.80 B 0.8B 1.6 B 320M 414M N/A

Users in

the USA

0.21 B N/A 0.22B 65 M 125M N/A

Users

outside of

USA

1.59B N/A 1.38B 255 M 289 N/A

Users in

the USA%

11.67% N/A 13.75

%

20.3% 30.19% N/A

Users

outside of

USA%

88.33% N/A 86.25

%

79.7% 69.81% N/A

Money

spending

on

Research (

in

Millions)

12,282 1,178 2,350 807

776 N/A

Portion of

spending

on

Research

16.3% 24% 27% 36.38% 25.95% N/A

Banned by China,

N Korea,

Cuba,

and some

Arab

nations

None Bangl

adesh, China

, Iran,

N Korea

and

Syria

China, N

Korea, and

some

Arab nations

None N/A

Sources: Digital Trends, Statista, Yahoo! Finance

The key takeaways from this table are that Facebook and

Alphabet are the leading competitors. They are in a positive life

cycle. They are the most profitable and have the largest user

bases. They also use their profits to do research & development

and attract intelligent and skilled people to join their companies.

Furthermore, more intelligent and skilled workers mean that

Facebook and Alphabet are more likely to invent new,

innovative products and attract more consumers, users, and

investments. Finally, they have more revenue and net income

than other competitors within the industry.

Almost every company spends a lot of money on research and

development, even those that aren’t in a good financial situation.

Generally, the spending on research and development is the

largest or the second largest part of spending, even more than

cost of goods sold. This means that these companies believe that

research is the future. For example, Twitter and LinkedIn have a

poor financial situation, but they still spend large portion of

budget on research because they believe new, innovative

products will help them to get out of their poor financial

situation.

In addition, companies in this industry are very international. For

example, for Alphabet, Facebook, or Twitter, over 70% of their

users come from outside of the United States. This means that

those companies are more likely to be impacted from

international situations. For example, the appreciation of the US

dollar has decreased about 6.25% of Alphabet’s total revenue.

Meanwhile, we find that these companies, which are successful

in the industry, always have more international revenue than

domestic revenue, such as Facebook and Alphabet. Therefore,

whether companies can generate enough revenue internationally

is a critical for companies' development.

Catalysts for Growth/Change

One factor driving the Internet Software & Services Industry

going forward is that the number of people using mobile devices

will continue to increase over the next few years. We believe

this means there is potential for companies to capitalize off this

and implement more mobile advertising to earn more profits

from the increase in these numbers. Another factor that will

drive the industry going forward is the amount of time people

A Leading Position

•Positive Revenue and Net income

•More Users and bettter reputation

More avaiable money to spend on research

•Providing better wages and Salaries

More intelligent people will join the companies

•Higher efficiency and new ideas

More popular products may be invented

•More users

•More customers

http://finance.yahoo.com/q?s=GOOG

http://finance.yahoo.com/q?s=YHOO

http://finance.yahoo.com/q?s=FB


8

spend online. We believe that people will continue to spend

more time online as technology continues to become more and

more advanced, which will lead to more advertising revenue and

lead to more growth within the industry.

Source: Statista

Key Investment Positives or Negatives

We believe that a key investment positive for the Internet

Software & Services Industry is that that companies’ market

capital has been increasing in the past 5-8 years and we believe

it will only continue to grow as this is a brand new industry and

has great potential for growth. We also believe that another key

invest positive is that the number of Internet users will continue

to increase, making the market itself larger in the process.

Source: Statista

We also believe that another key investment positive for the

industry is that highly-skilled workers tend to be hired

frequently, which helps successful companies within the

industry continue to be successful, innovative, and profitable,

which makes their shareholders happy.

We believe that a key investment negative for the Internet

Software & Services Industry is that if you are looking to invest

in a smaller company, you will have to be patient for a return on

your investment because while smaller companies have the

opportunity to generate positive income and see growth, it

usually takes a while for this to happen. We also believe that

another key investment negative for this industry is that

technology is changing rapidly, so a product that helps to make a

company successful and profitable today could be obsolete a few

years down the line and cause the company to incur losses rather

than generate profits.

COMPANY-SPECIFIC ANALYSIS

General Information

Facebook builds useful and engaging products that enable people

to connect and share through mobile devices and personal

computers. They also help people discover and learn about what

is going on in the world around them, enable people to share their

opinions, ideas, photos and videos, and other activities with

audiences ranging from their closest friends to the public at large,

and stay connected everywhere by accessing their products,

including Facebook, Instagram, Messenger, WhatsApp, and

Oculus (10k).

Corporate Strategy

The mission of Facebook is to give people the power to share and

make the world more open and connected.

In order to give its users the power to share and be more connected

with one another, Facebook has made mergers and acquisitions a

significant part of its corporate strategy. Facebook aims to make

acquisitions that will increase their specialized employees and

complementary, products, and technologies.

Because 92% of Facebook’s total revenues comes from

advertising, another part of its corporate strategy is to implement

strategies to increase its total user base so that they can continue

to increase their advertising revenue and overall company profits.

Life Cycle

It is difficult to determine the life cycle of a technology company

that relies on social media because social media is such a new

industry. There aren't many patterns to follow. However, we

believe Facebook is more than likely in its growth phase as we are

still seeing large increases in revenue, net income, and total user

base. For example, revenue and net income has increased 100%

since 2011. Also, Facebook’s monthly active users have increased

50% since 2012. (10k)

2010 2011 2012 2013 2014

TV 269 277 284 279 279

Tablet 21 98 119 142 163

PC 183 194 183 169 159

Smartphone 21 62 94 122 134

Raido 103 102 99 93 87

Nespaper 32 32 31 30 29

050

100150200250300

Time Spent on Media (in Minutes per Day)

TV Tablet PC

Smartphone Raido Nespaper

1024 11511365

15611751

20192224

24942705

29373174

0

500

1000

1500

2000

2500

3000

3500

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Total Internet Users (in Millions)

Number of Users Linear (Number of Users)


9

Source: 10k

Financial Summary (for Fiscal Year 2015)

The revenue and net income for Facebook has continuously been

positive and growing since 2012, thus showing that Facebook has

been in a healthy financial situation since then and we believe it

will continue to be in one. Facebook’s spending on research and

development, 26.86% of total revenue, is the company’s largest

expense. This portion of spending on research and development

has been increasing since 2011. The second largest expense of

Facebook is cost of revenue, which represents 15.99% of total

revenue. The cost of revenue has been decreasing since 2011.

Therefore, we believe that with the development of newer,

efficient technology, the cost of revenue will continue to decrease.

The large amounts of expenses for research and development

show that Facebook focuses its efforts on improving its current

products and developing new ones for its consumers when other

expenses keep at the same level. We believe that as long as

Facebook is able to continually decrease its cost of revenue, its

increasing expenses for research and development should only

benefit the company has it produces new, innovative products to

attract more consumers.

Source: 10k

Products and Markets

The product line of Facebook includes Facebook, Instagram,

Messenger, WhatsApp, and Oculus. Facebook is the same-name

social media network, Instagram is a photo-sharing social media

network, Messenger is an app used to message others through Wi-

Fi connectivity, WhatsApp is a cross-platform mobile messaging

app, and Oculus produces virtual reality hardware for video game

consoles. Facebook was founded in 2004, created Messenger in

2011, purchased Instagram in 2012, and purchased WhatsApp and

Oculus in 2014.

Source: Statista

Among all products, Facebook, the social network, has the highest

number of users in Facebook’s total user base. However, the

majority of Facebook’s users are over 35 years old. Therefore,

Facebook might have trouble retaining its future younger users.

2011 2012 2013 2014 2015

Revenue (inMillions $)

3711 5089 7872 12466 17928

Net Income(inMillions $)

1000 53 1500 2940 3688

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

20000

Net Income Compared to Revenue

Revenue (in Millions $) Net Income(in Millions $)

10561228

13931591

1800

0

500

1000

1500

2000

2012 2013 2014 2015 2016 E

Monthly Active Users (in millions)

Monthly Active Users

Linear (Monthly Active Users)

23.17%26.80%

23.82%

17.27%15.99%

10.46%

27.49%

17.98%

21.39%

26.86%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

2011 2012 2013 2014 2015

Expenses (% of Total Revenues)

Cost of Revenue Research and Development

1591

1000

800

400

0

Number of Users for Each Facebook Product (in Millions)

Facebook Whatsapp Messenger

Instagram Oculus


10

We believe that Facebook has realized this and have taken steps

to retain its younger users in other ways. For example, they

purchased Instagram and WhatsApp, whose consumers are

primarily younger people, which allows them to increase the total

number of younger people in their user base.

Source: 10k

Mobile devices and personal computers are the product markets

for Facebook. We believe Facebook has a huge potential in these

markets because even though cost per click will decrease over

time, the number of smartphone and internet users will continue

to grow in next five years, allowing to Facebook to capitalize off

this in terms of advertising. We are able to reach this conclusion

from historical records and the growth of total population. The

increasing number of people who use smart phones will benefit

Facebook and allow them to earn more revenue and profits as

more and more people gain access to its products. (eMarketer and

AP)

Source: 10k

Marketing Strategy

Facebook is able to increase its user base organically as its users

invite their friends and family to connect with them via

Facebook’s products, thus increasing the number of people who

use the products. Facebook also invests in marketing strategies

that promote their products and services in an attempt to build

their brand, grow their user base, and increase total user

engagement.

Source: 10k

The significant customers of Facebook are companies who are

looking to advertise on one of Facebook’s products.

Facebook generates a substantial portion of its total revenue from

selling advertising placements to these companies looking to

advertise. Over 92% of revenue comes from advertising. Since

2011, Facebook’s total revenue has increased over 20% every

year since then. We believe this pattern will probably maintain for

at least 3-5 years as more and more people utilize the internet as

a tool to conduct business.

Analysis of Recent Earnings Releases

On January 27th, Facebook released their earnings per share

for 2015. The consensus forecast was $0.50 per share and they

generated $0.59 per share. They were able to beat expectations by

over 18% and, as a result, their stock price increased by about

14% within one day. We believe that Facebook beating the

expectations for their total revenue is the reason their stock price

continues to increase. In the future, we expect Facebook’s stock

price to continue to increase due to the increasing numbers of their

user base and more companies start to use Facebook as a platform

to do advertisements. We also believe that Facebook’s user base

will be positively driven by the increasing number of smart phone

users. In particular, Asia would be a huge potential market for

Facebook since the American market is close to being saturated.

The United Sates & Canada currently have over 219 million

Facebook users with a total combined population of about 350

million people. Asia, however, has a larger population than the

US that has a large appetite for technologies. Facebook’s

increasing user base will attract more companies to use Facebook

as an advertising tool to be able to reach out to potential customers

within Facebook’s increasing user base.

Production and Distribution

The Internet is the distribution channel for Facebook. Laptops,

mobile phones, and tablets are the primary tools that people use

to access Facebook and its other products. People who have

23

17

16

26

28

22

19

26

19

15

11

18

12

13

16

0% 20% 40% 60% 80% 100%

Instagram

Whatsapp

Facebook

Demographic of Facebook Users' Ages

18-24 25-34 35-44 45-54 55-64 65+

10241151

13651561

17512019

22242494

27052937

3174

0

500

1000

1500

2000

2500

3000

3500

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Internet Users (in Millions)

Users numbers Linear (Users numbers)

17079

849

Total Revenues (In Millions)

Advertising Payments and other


11

accounts for Facebook and its other products are the suppliers of

Facebook. The more people that use Facebook, the more incentive

companies will have to pay money to Facebook to do advertise.

Competition

Facebook faces significant competition in every aspect of their

business, including from companies that provide tools to facilitate

communications and the sharing of information, companies that

enable marketers to display advertising, and companies that

provide development platforms for application developers. The

direct competitors of Facebook include Twitter, Alphabet,

LinkedIn, and Yahoo! All of these competitors are trying to

increase their user bases in an attempt to compete directly with

Facebook’s large user base.

Comparative Analysis

GOOG YHO

O

FB TWTR LNKD

Market

Cap:

466.93B 25.46

B

284.12B 9.95B 13.49B

Employe

es:

61,814 10,700 12,691 4,200 N/A

Qtrly

Rev

Growth

18% 2% 52% 58% 34%

Rev.

(ttm):

74.99B 4.97B 17.93B 2.22B 2.99B

Rev.

within

USA

34.8B

3.98B 8.51B 1.44B 1.85B

Rev.

outside

USA

40.1B

0.99B 9.415 0.78 B 1.14B

Rev.

within

USA%

46.4% 80.1% 47.46% 64.86% 61.87%

Rev.

outside

of

USA %

53.6% 19.9% 52.54% 35.14% 38.13%

Gross

Margin

(ttm):

0.62 0.58 0.84 0.67 0.86

EBITDA

(ttm):

24.42B 474.68

M

8.24B -208.40M 269.53

M

Oper.

Margin

(ttm):

0.26 -0.03 0.35 -0.24 -0.05

Net

Income

(ttm):

16.35B -4.36B 3.67B -556.15M -

166.14

M

EPS

(ttm):

23.78 -4.64 1.29 -0.86 -1.29

P/E

(ttm):

28.56 N/A 77.2 N/A N/A

PEG:

5yr

expected

1.18 -6.76 0.98 0.64 1.23

P/S

(ttm):

6.26 5.14 15.84 5.07 4.84

User

base

1.80 B 0.8B 1.6 B 320M 414M

Users in

the USA

0.21 B N/A 0.22B 65 M 125M

Users

outside

of USA

1.59B N/A 1.38B 255 M 289M

Users in

the

USA%

11.67% N/A 13.75% 20.3% 30.19

%

Users

outside

of

USA%

88.33% N/A 86.25% 79.7% 69.81

%

Mobile

Users

N/A 0.8 B 1,442B 256M 53m

Mobile

Users%

N/A 75% 90.12% 80% 12.8%

Money

spending

on R&D

(in

Millions)

12,282 1,178 2,350 807

776

Portion

of

spending

on R&D

16.3% 24% 27% 36.38% 25.95

%

Banned

in

China, N

Korea,

Cuba,

and some

Arab

countries

None Banglad

esh,

China,

Iran, N

Korea

and

Syria

China, N

Korea,

and some

Arab

countries

None

Source: 10Ks

Compared to its competitors, Facebook is the leading company.

One reason for this is because Facebook created its business

before some its competitors, cultivating a huge user base which

has grown to be five times larger than that of Twitter, LinkedIn

and Yahoo. Advertising companies will want to pick a social

media company to advertise through in order to reach the largest

numbers of people, so this puts Facebook at a large advantage

over its competitors.

Facebook’s large user base has allowed it to attract investments

from companies looking to advertise. In addition, more

investments from these companies’ means that Facebook can

spend more money on research and development to develop new

and innovative products to attract new consumers and continue to

increase its user base. Finally, Facebook will receive more

investments.

When some potential competitors emerge that are complementary

to Facebook and can provide some benefit to the company,

Facebook can use its cash and shares to acquire those companies,

such as it did with WhatsApp and Instagram. By acquiring these

emerging companies, Facebook can secure its leading position

and continue to innovate.

http://finance.yahoo.com/q?s=GOOG



http://finance.yahoo.com/q?s=FB


12

Compared to other social media companies, Facebook is the most

international company of them all. More than 50% of Facebook’s

total revenues come from operations outside of the United States.

More than 85% of its users live outside of the United States. We

believe this will show that Facebook has more international

reputation, meaning that Facebook could attract more potential

customers from Europe and Asia in the future. Also, large abroad

user base could bring international advertisement companies’

investment to

In addition, Facebook has a dominant position in the mobile

phone area. For example, 90.12% Facebook users use the mobile

as a channel to look up information, which is the highest one

among its competitors. We believe people will use mobile phone

more often in the next decade. Facebook could use mobile users

to attract advertisements companies.

Source: Statista

However, we believe that Facebook is facing challenges from a

different area. For example, even though Facebook has the largest

user base of all social media companies, younger people tend to

want to use Snapchat or Twitter, rather than Facebook. Therefore,

Facebook will have to make some changes and implement new

products and services that can attract younger users.

Source: Business Insider

Other Topics

R&D

Research and development costs for Facebook consists primarily

of share-based compensation, salaries, and benefits for employees

within their engineering and technical teams working on building

new products and improving existing products. R&D is the largest

cost within the Costs and Expenses section of the Facebook’s

2015 Income Statement, being $4.816 Billion. This shows that

Facebook is willing to invest heavily into maintaining their

current products and invest in new ones, such as connectivity

efforts, artificial intelligence research, and virtual reality (10k).

Foreign Sales

Because Facebook is a social network that is used globally, they

often generate revenues and profits in currencies other than the

USD. This means that Facebook is susceptible to Foreign

Currency Risks. Recently, in 2015,

Facebook experienced foreign currency exchange losses

of $66 million, which was down from the $87 million loss the

company incurred in 2014.

Government Regulation

Facebook is subject to a number of US Federal, State, and foreign

laws & regulations affecting many similar businesses on the

Internet. Notably, Facebook is primarily subject to laws involving

foreign data protection, privacy, and other restrictions that can be

more restrictive in foreign countries than those in the US (10k).

Composition of Board of Directors

Mark Zuckerberg is the founder, Chairman, and CEO of

Facebook. He is in charge of providing the overall direction and

product strategy for the company. He also leads the design of

Facebook’s service and development of its core technology and

infrastructure (Facebook).

488751

9501189

1442

0

500

1000

1500

2000

2012 2013 2014 2015 2016

Numbers of mobile users (In millions)

Numbers of Users (In millions)

Linear (Numbers of Users (In millions))

0% 20% 40% 60% 80% 100%

Snapchat

Instagram

LinkedIn

Twitter

Facebook

Demographic of Users' Ages for the Top Social Media Companies

18-24 25-34 35-44 45-54 55-64 65+


13

Major Stockholders

Within Facebook, Mark Zuckerberg only owns 20% of total stock.

However, Facebook is structured in a way that makes it a “dual

class” company. Zuckerberg owns about 20% of the company, but

almost all of his stock is “class B” stock, which gets ten votes for

every one vote given to regular “class A” stock. Therefore, Mark

Zuckerberg has a superior control over the company, being the

largest voting power. Almost all other majority shareholders are

passive hedge funds. These other majority shareholders being

passive helps to strengthen the control rights of Mark Zuckerberg.

Payout Policy

Facebook has never declared or paid cash dividends on their

stock, nor do they intend to do so within the foreseeable

future. Instead, Facebook invests retained earnings back into the

company itself and uses their earnings to finance current and

future operations and expand their business (10K).

Catalysts for Growth/Change

One catalyst for growth and change for Facebook is its growing

user base, which means that Facebook has the opportunity to

capitalize off this and increase their total revenues. Another

catalyst for change and growth for Facebook is their large market

capital, which allows them to be able to acquire

other companies and technologies which will complement and

benefit Facebook. Another catalyst for growth and change for

Facebook is the fact that it has been investing a lot into research

& development, which allows them to be able to maintain their

current products and invest in newer, innovative products which

will attract new users.

Key Investment Positives/Negatives (S.W.O.T. Analysis)

Strengths

Facebook’s growing user base helps to contribute to its increasing

average revenue per user as its total revenues also continue to

increase.

The growing user engagement for the consumers of Facebook’s

products increases appeal for advertisers and makes them want to

purchase more ad space.

Facebook’s lucrative user base will provide value for companies

and developers looking to advertise through Facebook’s products

as Facebook has the largest user base among all social media

companies.

Weaknesses

Facebook has a high dependency on advertising revenues, as it

makes up 92% of its total revenues, which puts Facebook at

significant risk because should something happen to the company

which negatively impacts its advertising revenues, Facebook

could incur heavy losses.

Facebook is still currently in its growth phase, so the historical

growth figures that it has had will be close to impossible to

maintain as it reaches its maturity phase over time.

Even though Facebook bought Instagram and WhatsApp to bring

younger users into its user base, we do not believe that Facebook

will be able to maintain its 70% market share due to fierce

competition.

Over 85% of Facebook's users are from outside of the United

States, but only 53% of its revenue comes from outside of the US.

We have doubts that Facebook will be able to convert their user

base into actual revenue outside of the US. If Facebook cannot

successfully do this, then their revenue growth rate will be

negatively affected.

Opportunities

There has been strong growth in overall US digital display

advertisement spending which means that Facebook could see an

increase in companies looking to purchase ad space through their

products.

There has been growth in overall mobile advertising worldwide,

which means that Facebook could capitalize off this through ad

spaces on their products.

New product offerings by Facebook, such as the recent release of

the Oculus Rift, will provide some revenue diversification and

help Facebook decrease the risk that is involved in advertising

revenue making up such a significant portion of their total

revenues.

Threats

Facebook is always facing intense competition as the Internet

Software & Services Industry is one of the most competitive

environments in which to operate.

Facebook operates within a stringent

regulatory environment which could deter them from

implementing strategies that may benefit the company, but aren’t

allowed to due to regulations.

In an age where cyber-crime has been increasing, Facebook faces

the threat of potential security breaches

which may negatively impact the overall reputation and

business of the company (MarketLine).

VALUATION DISCUSSION

Revenue Decomposition

To forecast Facebook’s future revenue. We first looked at

Facebook’s historical revenue. We noticed that they had

increasing revenue along with an increasing user base.

Therefore, we divided revenue by users to get revenue per

users. Then, we used the user base and revenue per users as

our standards to forecast revenue.


14

Right now, we believe that the ceiling of total Facebook users

is 2 billion users since the world Internet users is 3 billion and

over 600 million Chinese potential users are not allowed to

use Facebook within China. However, as time goes by, we

believe that Internet users will increase to about 4 billion with

the increase of accessibility of the Internet in developing

countries and the growth of the overall population of the word.

Also, with globalization, China will eventually open to

Facebook in the next few decades. Therefore, we predict that

Facebook users will grow to about 3 billion in 2025.

The revenue per users will continue to grow since more and

more people start to use social media as a tool to do

advertisements. However, the growth rate will not remain at

30% every year. We believe the growth rate will gradually go

down smoothly over the next 10 years.

If we combine those two factors together, we believe that the

revenue of Facebook will go up, but the growth rate will go

down over the next decade.

Cost of Goods Sold

Although Facebook's revenue has been increasing, we

actually noticed that the the cost of goods sold has been

decreasing since 2011. This is mainly because the main

channel of Facebook is internet which is almost free for

Facebook to use. Therefore, Facebook does not have to spend

money on depreciation and amortization and other tangible

goods. Meanwhile, with the development of newer

technology, the cost of materials is going down. For example,

the price of fiber optics have going down over the past

century. Therefore, we believe the cost of goods sold will

continue to go down in the next ten years until reach to a low

level.

Research and Development

The cost of research and development is the biggest cost for

Facebook, and it has been going up since 2012. As a social

media company, it is very important for Facebook to invent

popular products in order to attract and retain users. In the

Internet Software & Service Industry, almost every

company spends more than 20% of their total revenue doing

research and development. Therefore, we believe that

Facebook will continue to invest money in doing research.

And cost of research and development will remain as

Facebook's largest cost.

Discounted Cash Flow and EP Model

Our Discounted Cash Flow analysis and Economic Profit

model both indicated that the intrinsic stock price is $60.92.

We changed this value to reflect that some of 2016 has been

passed. As 04/19/2016, Facebook’s stock price was 110.45.

The current stock price over our prediction over 80.17%.

We believe that those difference actually comes from the

estimation of future growth rate. We believe that the

revenue growth will gradually go down in the next ten

years.

Dividend Discounted Model

We do not think Dividend Discounted model will work

accurately for Facebook since Facebook never pays

dividends. We also believe Facebook might never pay

dividends since Mark Zuckerberg says he will not pay

dividends to investors, but rather take the earnings and

invest it back into the company itself.

Relative Valuation Model

We choose to compare Facebook with its direct and indirect

competitors to see how the company is valued relative to

other companies which are in the same industry. To look at

value of Facebook, we used P/E for 2016 and 2017 of our

comparison companies.

The comparison of the companies includes the biggest

company of the industry, old companies, and new

companies. Therefore, our evaluation is very

comprehensive.

Our relative P/E in 2016 shows that the industry average

price is 21.6, which is not very helpful to forecast since

Facebook has a dominant position in the social media area.

Therefore, people might only invest in Facebook. However,

for PEG ratio, the forecast price matches with what we

have.

Weighted Average Cost of Capital

We calculated Facebook's WACC to be 7.08%. Our WACC

estimate included total equity and operating leases. Total

equity has over 99.5% weighted average, which makes

WACC and Cost of Equity very close.

Beta

We got a one-year average raw beta from Bloomberg of

0.972.

Cost of Equity

In order to calculate the Cost of Equity for Facebook, we

got the raw beta from Bloomberg, which is 0.972. Then, we

used the current 30-year Treasury Yield as the risk free rate

and used the market return and historical 30-year Treasury

Yield as the risk premium which is 4.57%. Finally, we

multiplied the risk premium times the raw beta plus risk free

rate. The final value of our Cost of Equity is 7.10.

Cost of Debt

Facebook does not have much debt. Due to high gross

profit, they store lots of cash in their company. The only

debt Facebook has is for its operating leases. Since

Facebook does not issue any bonds, we had to look at

similar company, like Apple, as a reference. We used a 30-

year corporate bonds since it represented the longest period

of Apple's corporate bonds.


15

SENSITIVITY ANALYSIS

Our evaluation models are based on the assumptions which

we believe are highly volatile. We wanted to find a range of

data for our future stock price when some variables change.

In addition, we wanted to look at how sensitive some of our

factors are.

WACC to ROIC When WACC is held constant, our stock price goes up a little

bit when ROIC goes up. The range is from 60.74 to 61.09.

When ROIC is held constant, our stock price goes down with

the increase of WACC. The range is from 56.22 to 67.02.

Therefore, our stock price is not very sensitive to change with

the change in ROIC. On the other hand, our future price will

be largely influenced by the interest rate.

Cost of Debt to Marginal Tax Rate When Cost of Debt is held constant, our stock price only

made a little change with the changes of Marginal tax rate.

We believe our stock price is not sensitive to the tax since

over 99% of the moving average weighted debt is equity. No

matter how the marginal tax rates change, our stock price

generally stays a constant level as long as Facebook doesn't

have much debt.

CV Growth to WACC When CV Growth is held constant, the stock price will

become lower with the increasing value of WACC. The stock

range changes from 60.18 to 61.97. Therefore, we think

WACC has a huge impact on our stock price. Therefore, if

interest raises in the future, the WACC will go up, and our

stock price will go down.

Equity Risk Premium to Beta

When Beta is held constant, our stock price varied from 59.16

to 62.70. When Risk Premium is held constant, our stock

price decreased as beta increased, from 64.42 to 49.16. We

believe that Facebook has outperformed than the S&P. The

more similar Facebook is to the market, the lower Facebook's

price will go.


16

IMPORTANT DISCLAIMER

This report was created by students enrolled in the Applied

Equity Valuation (FIN:4250:0001) class at The University of

Iowa. The report was originally created to offer an internal

investment recommendation for The University of Iowa

Krause Fund and its advisory board. The report also provides

potential employers and other interested parties an example

of the students' skills, knowledge, and abilities. Members of

the Krause Fund are not registered investment advisors,

brokers, or officially licensed financial professionals. The

investment advice contained in this report does not represent

an offer or solicitation to buy or sell any of the securities

mentioned. Unless otherwise noted, facts and figures

included in this report are from publicly available sources.

This report is not a complete compilation of data, and its

accuracy is not guaranteed. From time to time, The

University of Iowa, its faculty, staff, students, or the Krause

Fund may hold a financial interest in the companies

mentioned in this report.

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10K, Facebook. FACEBOOK INC. MENLO PARK, CA 94025:

Facebook, 2016.

<http://files.shareholder.com/downloads/AMDA-

NJ5DZ/1546151477x0xS1326801-16-

43/1326801/filing.pdf>.

Analysts, Thomson One. Thomson One. 16 Feb 2016.

<https://www.thomsonone.com/Workspace/Mai

n.aspx?View=Action%3dOpen&BrandName=www

.thomsonone.com&IsSsoLogin=True>.

BBC. Google services set for 'return' to China. N/A: BBC

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CNBC. "Facebook buying virtual reality firm Oculus for $2

billion." Tuesday Mar 2014. CNBC.

<http://www.cnbc.com/2014/03/25/facebook-

buying-virtual-reality-firm-oculus-for-2-

billion.html>.

Cordray, Robert. Net Neutrality's Effect on Advertising.

N/A: Digitalist Magazine, 2014.

eMarketer and AP. "Number of smartphone users*

worldwide from 2014 to 2019 (in millions)." Feb

2016. statistics.

<http://www.statista.com/statistics/330695/num

ber-of-smartphone-users-worldwide/>.

Facebook. Board of Directors. Feb 2016.

<http://investor.fb.com/directors.cfm>.

Kessler, Scott. Industry Surveys: Internet Software &

Services. New York: S&P Capital IQ, 2015.

MarketLine. "Facebook, Inc." 28 January 2016.

Marketline, Advantage.

<http://advantage.marketline.com/Product?pid=

679613FB-9911-4907-8C86-9902F9D5BEF4>.

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<http://www.netadvantage.standardandpoors.co

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<http://www.statista.com/statistics/253577/num

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http://www.sec.gov/edgar/searchedgar/company

search.html

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LinkedIn Corporation. (2016, 2 12). Retrieved from EDGAR

| Company Filings:


4/000127102416000035/a20151231-

10xkdocument.htm

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http://www.statista.com/statistics/277958/numb

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4th quarter 2015 (in millions). (2016). Retrieved

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https://www.google.com/url?sa=t&rct=j&q=&esr


17

c=s&source=web&cd=4&cad=rja&uact=8&ved=0a

hUKEwiPoumd1ZvMAhUjnoMKHcmTBaoQFggsM

AM&url=http%3A%2F%2Fwww.statista.com%2Fst

atistics%2F264810%2Fnumber-of-monthly-active-

facebook-users-

worldwide%2F&usg=AFQjCNG66i13xIgO

Number of monthly active WhatsApp users worldwide

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http://www.statista.com/statistics/260819/numb

er-of-monthly-active-whatsapp-users/

Patterson, M. (2015, May 4). Social Media Demographics

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http://sproutsocial.com/insights/new-social-

media-demographics/

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https://www.cia.gov/library/publications/the-

world-factbook/fields/2195.html

Twitter, Inc. (2016, 2 29). Retrieved from EDGAR |

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1/000156459016013646/twtr-10k_20151231.htm

Yahoo! Inc. (2016, 2 29). Retrieved from EDGAR |

Company Filings: http://www.sec.gov/cgi-

bin/browse-

edgar?CIK=yhoo&owner=exclude&action=getcom

pany


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Documents

Krause Fund Research Technology (Alpha) · 2016-06-21 · Spring 2016 F Facebook, Inc. (NASDAQ: FB) Recommendation: NO ACTION Current Price: $110.45 April 19, 2016 . Important disclaimer