The No. 1 Metric Facebook (FB) Investors Must Watch

When shares of Facebook (FB) fell 19% in a single trading session in July, did it get your attention?

It should have.

The social media titan lost more than $120 billion in market cap that day – the biggest such loss in history.

If a big, sudden loss like this can happen to market darling Facebook, everything else in your portfolio is fair game.

Ask most investors what causes big, sudden moves like this. Most of them won’t really know. But these big shake-ups tend to have something in common. Today, I would like to reveal it to you.

Armed with this information, you’ll be better-positioned than ever to spot danger and opportunity.

Facebook’s one-day meltdown provides an ideal case study of both…

On the evening of July 25, Facebook executives held a conference call to discuss second-quarter results. They also provided a peek into the company’s future.

What they said about Facebook’s future was shocking.

Before I get into those details, keep in mind the three factors that generally have the greatest influence on stock prices…

  1. A change in expectations for revenue growth.
  2. A change in expectations for operating profit margins (what’s left after deducting the cost of goods sold and other operating expenses, such as salaries).
  3. A change in expectations for free cash flow margins (the residual cash left after accounting for changes in working capital and deducting capital expenditures).

When investors get new information that suggests growth is accelerating, or that margins are expanding, their expectations about the magnitude of future cash flows also rise – sending the share price higher.

Of course, this dynamic also works in reverse. If new information causes investors to lower their expectations for growth and/or margins, this translates into lower expected future cash flows, and, in turn, a lower stock price.

This is precisely what happened on July 25, sparking the massive sell-off in Facebook shares after hours and into the next day.

On that conference call, Facebook executives surprised investors with news that each of the three factors – revenue growth, operating margins, and free cash flow margins – would be under additional pressure in the quarters ahead. Let’s take a closer look at what they said and why it altered investor expectations so drastically.

First up was the sudden deceleration in revenue growth…

Prior to the recent earnings announcement, investors had noticed that Facebook’s revenue growth rate, though still high, was trending down a few percentage points year over year. This is normal. Even for businesses like Facebook, growth rates are expected to gradually slow as competition increases and market penetration reaches its practical limits.

But during the call, Chief Financial Officer David Wehner alerted analysts that the downward trend for growth rates was suddenly picking up speed. He noted it would fall by high single digits for the remainder of 2018.

In other words, Facebook management was telling investors that they needed to dial back their expectations for revenue growth.

Next, Facebook’s operating margins are facing additional pressure…

When a company experiences a sudden or unexpected decline in revenue growth, it will often scale back operating expenses to mitigate the impact. But not Facebook… It’s hitting the accelerator.

Last quarter, expenses grew at a faster rate than revenue for the first time in at least two years. That’s because the company is spending heavily on two areas crucial to its business: data security and keeping customers safe from harassment, terrorism, and hate speech.

Importantly, management expects this heavy spending to continue this year and next, and it’s now projecting operating margins in the mid-30% range within a few years, compared with levels that had historically been in the mid-to-upper 40% range.

The third significant, negative surprise investors had to deal with was significantly lower free cash flow margins…

This was due to heavy spending on new data centers and other capital projects. Capital expenditures are likely to consume about 26% of revenue this year, a significant increase from 17% in 2017.

In short, Facebook’s 19% one-day plunge was the result of sharp, sudden changes in investor expectations…

This is what big stock moves almost always have in common.

In the chart below, you can see our estimates of the specific expectations that were implied in Facebook’s share price before and after the new lowered guidance from management for the next three years…

If you learn just one thing from reading today’s essay, I hope it’s this: Changes in investor expectations about future cash flows like the ones I’ve outlined above are what ultimately push equity prices higher or lower. Markets always look forward.

None of us can consistently and accurately predict the future. And yet, stock prices always reflect the collective expectations of market participants.

This dichotomy sets the stage for the danger and opportunity I noted earlier.

On one hand, investors tend to expect the near future to look a lot like the recent past. This is exactly what Facebook investors buying shares near their all-time highs were doing – and they got burned.

On the other hand, opportunity often lies in the disconnect between the market’s expectations and a well-informed, contrarian viewpoint.

To illustrate this, let’s return to Facebook, where one of the big changes ahead is the shifting landscape in social media…

For years, Facebook’s News Feed feature has been the preferred medium for users to share content. The advertising business developed around it has become a free cash flow gusher.

But soon, the company’s “Stories” format – short photo and video streams that disappear after 24 hours – will become the primary way that users share content.

This has big implications for Facebook’s business model, and it’s the primary reason revenue growth rate expectations are being dialed back. Here’s what Chief Operating Officer Sheryl Sandberg had to say about it during the second-quarter call…

We’ve seen great progress with Stories as a format for people to share on our platforms. We have 400 million people sharing with Instagram Stories, 450 million with WhatsApp Status. Facebook is newer [about 150 million users], but we’re seeing good progress there.

The question is, will this monetize at the same rate as News Feed? And we honestly don’t know. We’ll have to see what happens. There are good reasons to be very optimistic about the monetization.

Those reasons for optimism are currently lost on Facebook investors…

Earlier, I noted Facebook executives adjusted revenue growth rate guidance for the last two quarters of 2018 down by high negative single digits. According to our Extreme Value models, investors immediately extrapolated that high negative single-digit trend forward an additional three years.

In other words, within a matter of hours, the expectations pendulum swung from “it’ll never rain again” to “it might never stop.”

We’ve now identified the single most important metric Facebook will report for at least the next couple of quarters. We’ve also identified a potential source of upside in the stock – the trend outlook for revenue growth rates.

If Stories’ advertising platform looks like it’ll take off soon, the forecasted deceleration implied into 2020-2021 would suddenly look much too pessimistic. As investors adjust their expectations higher for future cash flows, the stock could easily pop 25%-30%.

On that note, an important piece of wisdom appears on page 57 of famed investor Howard Marks’ classic investing book, The Most Important Thing:

Great investors are those who take risks that are less than commensurate with the returns they earn…

This is a laudable goal for every investor. However, waiting for price setups where the rewards clearly outweigh the risks requires extraordinary patience – particularly more than nine years into this historic bull market.

Facebook shares have significant upside, depending on how long the negative revenue growth rate trend extends beyond management’s own guidance. But it’s difficult to argue that the potential returns outweigh the risks at the current share price. After all, even Facebook executives aren’t sure how quickly, or to what degree, the new Stories format will monetize.

We can’t predict the future. That’s why picking stocks is so difficult. But thinking about how expectations will change – and how those changes will influence future cash flows – can help you spot both danger and opportunity… and put you far ahead of most investors.

Good investing,

Mike Barrett

Source: Daily Wealth