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Facebook worker Holly Daniels, right, helps attendees in line at the sold-out Facebook Fit ‘Small Business Boot Camp’ at Austin Music Hall on July 24 in Austin, Tex. (Darren Abate)
Facebook worker Holly Daniels, right, helps attendees in line at the sold-out Facebook Fit ‘Small Business Boot Camp’ at Austin Music Hall on July 24 in Austin, Tex. (Darren Abate)

strategy lab

Sell Facebook? Not when its earnings may double Add to ...

Chris Umiastowski is the growth investor for Globe Investor’s Strategy Lab. Follow his contributions here and view his model portfolio here.

Facebook Inc. hit a new all-time high after reporting quarterly earnings last week. Although I started writing for Strategy Lab in September, 2012, it took me until November, 2013, to understand the power of Facebook’s business model and add shares to my model portfolio (disclosure: I also own it personally). But now that the stock has climbed 60 per cent in eight months, shouldn’t I take my profit and move on?

No chance. While I certainly didn’t expect gains to come this fast, I’m also not the type of investor to try to time stocks for short-term gains. I bought Facebook because I noticed how quickly they were improving their advertising product and successfully making money from a growing audience of mobile device users. People on phones and tablets make up the majority of Facebook traffic today, and being able to effectively advertise to this audience is critical.

Let’s take a quick look at last quarter’s results. Facebook’s daily user base is now 829 million strong, up 19 per cent year over year. Revenue reached $2.9-billion (U.S.), which is a 61-per-cent increase over last year. Operating margin reached an unbelievable 59 per cent, up from 44 per cent last year as Facebook has scaled revenue much faster than its cost of revenue. Earnings per share reached $0.42 compared to $0.19 last year. That’s a 121-per-cent growth rate.

Prior to last week’s earnings release, analysts pegged Facebook to earn $1.44 this year and $1.84 next year. Even if Facebook stopped growing now, it’s on track to reach $1.68 in earnings over the next 12 months. Even with a $75 stock price, this puts the price to earnings ratio at 45. If Facebook wasn’t growing so fast, I would object at the valuation and sell my shares. But I think the growth will continue.

Here are three things longer-term investors should consider:

Facebook’s audience is still growing

Much of that growth is coming from emerging markets, where advertising rates are much lower. But the rates are not zero, and there is still immense profit to be earned. Revenue from outside North America and Europe was 26 per cent of Facebook’s total last quarter and is showing faster growth than developed countries.

Advertising rates still have plenty of room to move higher

I believe Facebook will smartly increase rates over time once it gets an even larger audience of advertisers comfortable making long term plans to use their platform. Every extra penny per click is pure profit.

Facebook still has lots of room to increase the ‘fill rate’ of ads

The “fill rate” refers to the proportion of content space taken up by ads instead of organic content from your friends. While there are always people who will complain about any number of ads on a free service, my opinion is that Facebook could easily show 50 per cent more ads without disrupting the user experience.

Online marketers often talk about the triple force of traffic, conversion and price. Imagine you run an online store and you can successfully raise your traffic, increase the number of visitors who end up buying, and charge more for each sale. Now, imagine the product is digital, so it has very little actual cost to produce. Your expenses likely rise slower, so your operating margin keeps rising.

This is the position I feel Facebook is in over the next decade. They have audience growth covered. They’re continually launching better ad tools (such as autoplay video ads) and they have plenty of room to raise prices over time.

It would not surprise me if Facebook’s earnings double in the next three years, which should leave plenty of room for upside in the stock.

 

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