Facebook – House of Cards?

Stories in the media about fake news, Russian trolls, secretive organisations like Cambridge Analytica improperly using personal data to influence political elections – it all sounds like something out of an episode of House of Cards.

Despite Mark Zuckerberg and Sheryl Sandberg’s claims that Facebook will do better in the future, shareholders have voted with their feet. Facebook’s shares are down ~16% (at time of writing) since the data sharing scandal broke.

But despite the negative news flow and share price sell off, Facebook is still huge in stock market terms. Today it has a market capitalisation of $442 billion, making it the 7th largest company in the world. As recently as February 2017 it was the 5th largest company globally.

Facebook is a highly profitable business. Last year it generated over $15bn in net profit. But in early 2018 investors were willing to pay over 35 times this profit stream to own shares in the company.

This is an eyewatering multiple in my view. But on other metrics Facebook is nowhere near as large as this lofty stock market valuation.

The company employs just over 25,000 individuals, a similar number as “Tractor Supply Company” (an operator of retail farm stores in rural parts of the US). And this employee number is following a period of strong headcount growth. Back in 2011 Facebook had just 3,200 employees.

You’ll be hard pressed to find many S&P 500 companies outside of the property sector that employ less than 3,200 people.

Obviously, Facebook and Tractor Supply are entirely different business models. So, comparing employee numbers is somewhat unfair. But it gives an indication of the nature of Facebook’s business model & the astronomical nature of its stock market valuation.

Another metric that is worth considering, when thinking about the size and valuation of Facebook, is research and development expenditure (R&D).

One might reasonably expect that a large technology company like Facebook spends a huge amount of money on R&D. And in some ways, they do… last year the company spent over $7.5bn on R&D. But this puts them well outside the top 10 of global R&D spenders.

In 2016 – a year that Mark Zuckerberg admits Facebook “was not on top of the number of issues as it should have been” – the company was spending ~$6bn on R&D. This is the same amount as Google was spending in 2012, 4 years prior. It almost goes without saying – 4 years is a lifetime in the technology sector.

We’ll never know whether the Facebook data sharing and privacy issues could have been prevented if the company had spent more on R&D or employed more people. A more established company might have had better internal controls and processes in place, but it’s impossible to say for certain.

Nevertheless, the recent events highlight the risks and challenges investing in high growth companies trading on expensive near-term valuations. Such stocks are often priced for perfection. They offer little downside protection to the inevitable missteps that occur, or the increased oversight and regulatory scrutiny that comes from being a dominant industry player.

When unexpected bad news comes along, share prices can quickly come crashing down…….. rather like a house of cards.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.