Question

Slim Perkins, a business journalist, is a recent hire at his firm. Since he joined the firm, he has been following Facebook Inc.’s (FB) initial public offering (IPO) and the stock’s performance. His task is to estimate Facebook’s fair market value, also referred to as “intrinsic” value, and compare this value with the current stock price, and recommend a buy, sell, or hold rating to investors. Slim pulls the company’s consolidated financial statements to collect relevant data on the company’s historical financial performance.

He notices that the company assumes a 45% marginal tax rate after the IPO, and mentions that the company projects that user rates and revenue growth will decline over time.

Slim starts his evaluation by calculating ratios of costs and expenses to revenues, interest expense to revenues, and others that will form the set of assumptions in his analysis which will be used to calculate free cash flows.

Balance Sheet:

	2011	2010	2009
	(in millions)	(in millions)	(in millions)
Assets
Cash and cash equivalents	$3,908	$1,785	$633
Receivables	547	373	—
Prepaid expenses and other current assets	149	88	—
Total current assets	$4,604	$2,246	—
Property and equipment, net	1,475	574	$148
Goodwill and intangible assets, net	162	96	—
Other assets	90	74	—
Total assets	$6,331	$2,990	$1,109
Liabilities and equity
Accounts payable	$63	$29	—
Platform partners payable	171	75	—
Accrued expenses and other current liabilities	296	137	—
Deferred revenue and deposits	90	42	—
Current portion of capital lease obligations	279	106	—
Total current liabilities	$899	$389	—
Capital lease obligations, less current portion	398	117	—
Long-term debt	—	250	—
Other liabilities	135	72	—
Total liabilities	1,432	828	241
Convertible preferred stock	615	615	—
Common stock	—	—	—
Additional paid-in capital	2,684	947	—
Accumulated other comprehensive loss	(6)	(6)
Retained earnings	1,606	606	—
Total stockholders’ equity	$4,899	$2,162	$868
Total liabilities and stockholders’ equity	$6,331	$2,990	—

Income Statement:

2011	2010	2009
(in millions)	(in millions)	(in millions)
Revenue	$3,711	$1,974	$777
Costs and expenses
Cost of revenue	860	493	223
Marketing and sales	427	184	115
Research and development	388	144	87
General and administrative	280	121	90
Total costs and expenses	$1,955	$942	$515
Income from operations	$1,756	$1,032	$262
Interest and other income (expense), net:
Interest expense	$(42)	$(22)	$(10)
Other income (expense), net	(19)	(2)	2
Income before provision for income taxes	$1,695	$1,008	$254
Provision for income taxes	695	402	25
Net income	$1,000	$606	$229
Net income attributable to participating securities	332	234	107
Net income attributable to class A and class B common stockholders	$668	$372	$122

Statement of Stockholder's Equity

Balances at Dec 31
(in millions)	(in millions)	(in millions)
	2011	2010	2009
Convertible preferred stock	$615	$615	$615
Class A and Class B common stock	—	—	—
Additional paid-in capital	2,684	947	253
Accumulated other comprehensive loss	(6)	(6)	—
Retained earnings (accumulated deficit)	1,606	606	—
Total stockholders’ equity	$4,899	$2,162	$868

Statement of Cash Flows

2011	2010	2009
(in millions)	(in millions)	(in millions)
Cash flows from operating activities
Net income	$1,000	$606	$229
Adjustments to reconcile net earnings to net cash from operating activities:
Depreciation and amortization	323	139	78
Loss on write-off of assets	4	3	1
Share-based compensation	217	20	27
Other adjustments	—	—	(1)
Changes in assets and liabilities:
Accounts receivable	(174)	(209)	(112)
Prepaid expenses and other current assets	(31)	(38)	(30)
Other assets	(32)	17	(59)
Accounts payable	6	12	(7)
Platform partners payable	96	75	—
Accrued expenses and other current liabilities	38	20	27
Deferred revenues and deposits	49	37	1
Other liabilities	53	16	1
Net cash provided by operating activities	$1,549	$698	$155
Cash flows from investing activities
Purchases of property and equipment	$(606)	$(293)	$(33)
Purchases of marketable securities	(3,025)	—	—
Maturities of marketable securities	516	—	—
Sales of marketable securities	113	—	—
Investments in non-marketable equity securities	(3)	—	—
Acquisitions of business, net of cash acquired	(24)	(22)	3
Change in restricted cash and deposits	6	(9)	(32)
Net cash used in investing activities	$(3,023)	$(324)	$(62)
Cash flows from financing activities
Net proceeds from issuance of convertible preferred stock	—	—	$200
Net proceeds from issuance of common stock	$998	$500	—
Proceeds from exercise of stock options	28	6	9
Proceeds from (repayments of) long-term debt	(250)	250	—
Proceeds from sale and lease-back transactions	170	—	31
Principal payments on capital lease obligations	(181)	(90)	(48)
Excess tax benefit from share-based award activity	433	115	51
Net cash provided by financing activities	$1,198	$781	$243
Non-cash financing activities:
Property and equipment acquired under capital leases	473	217	56

Complete the following table.

Note: When entering intermediate calculations, round to two decimal places, but do not round the intermediate calculations when determining final answers. Round all percentages to two decimal places.

Estimated Assumptions	2011	2010	2009	Average
1. Total cost and expenses as a percentage of revenue	%	%	%	%
2. Operating current assets (in millions)			–	–
3. Growth in operating current assets	–	–	–	%
4. Operating current liabilities (in millions)			–	–
5. Growth in operating current liabilities	–	–	–	%
6. Depreciation and amortization as a percentage of revenues	%	%	%	%
7. Net fixed assets as a percentage of revenues	%	%	%	%

Slim posts his strategy on his social networking page to get some suggestions from his friends. Follow the discussion and complete the missing information:

Since Facebook named Google as its prime competitor,[1]I am inclined to use Google Inc.’s post-IPO performance as a benchmark for FB’s expected financial performance for at least three to four years following the IPO. Does anyone already have the growth rates for Google’s post-IPO revenues?

NATALYA: Hi Slim, according to a trading blog [2]I follow, Google’s post-IPO average revenue growth over five quarters was 18%.

SLIM: Thank you, Natalya! I also discovered in the annual report that FB’s internal projections use a 5% perpetual growth rate. I will be using a two-stage discounted cash flow model. I will base my FCF calculations on the following equation:

FCF = Net Operating Profit After Taxes + Depreciation – Capital Expenditure – ∆ in Net Operating Working Capital

Am I missing something?

TED: Slim, just one very important point. In your NOWC calculations I recommend using the growth in current assets as the assumption for growth in current liabilities after two years because current liabilities cannot grow faster than current assets forever. Such rundown on WC is not sustainable.

You could use Google’s WACC in your calculations. Google is currently using a 9.5% WACC. Investors would require an additional premium of 5.5% for Facebook’s stock.

SLIM: Thanks, Ted! This information is really helpful. Using Google as a comparable, it would be fair to use these values to calculate FB’s investors’ required rate of return, which will be(15% / 10% / 8% / 9%).

After discussing the different aspects of the valuation, Slim puts together his FCF projections. Complete the missing elements from his projection:

Note: When entering intermediate calculations, round to the nearest whole number, but do not round the intermediate calculations when determining final answers. For example: If the revenue growth rate is 11%, and the answers for revenue for 2012-2014 are 1103, 1224.33, and 1359.0063, then you should enter 1103, 1224, and 1359 as answers, but use 1359.0063 to calculate the revenue for 2015. If your answer is negative, use a minus (-) sign.

	2012	2013	2014	2015	2016	2017	2018
	(in millions)	(in millions)	(in millions)	(in millions)	(in millions)	(in millions)	(in millions)
Revenue growth rate	18%	18%	18%	18%	18%	5%	5%
Revenues	$	$	$	$	$	$	$
– Total costs and expenses
Income from operations (EBIT)
– Taxes
Net operating profit after taxes (NOPAT)
Operating current assets
Operating current liabilities
NOWC
Change in NOWC
Net fixed assets (plant property & equipment)
Change in net fixed assets
+ Depreciation and amortization
Capital expenditure
Free cash flow
Present value of FCF
Horizon value	—	—	—	—	—	—
Present value of horizon value	—	—	—	—	—	—
Total firm value	—	—	—	—	—	—

The value of total long-term liabilities that FB reported in 2011 was

million, and the value of preferred stock in 2011 was

million. Thus, using the firm’s value, the derived equity value will be

million. The company issued 421,233,615 shares of class A common stock in 2012. Thus, the value of each stock, rounded to two decimal places, is

.

According to the SEC filings, FB stock’s IPO was priced at $38.00 per share. If Slim strictly follows the theoretical rules of investing, based on his analysis, what strategy would he recommend to investors interested in FB’s stock as an asset in their short-term investment portfolio?

	Buy	Hold	Sell

Answer 1

The value of long-term liabilities that FB reported in 2011 was $398 million, and the value of preferred stock in 2011 was $615 million. thus, using the firm value, the derived equity value will be $3,039.6 million. the company issued 388 million shares of class A common stock in 2012. Value of each stock is 7.8.

Note: the firm value will actually be based on total shares outstanding and not just issued, in the given question I have taken into account the issued shares to calculate implied share price.

Rating = sell, based on DCF analysis with the given assumptions.

	2011	2010	2009	Average
Revenue	3711	1974	777
Cost and expenses	1955	942	515
%	53%	48%	66%	56%
Operating current assets	696	461
Growth	51%			51%
Operating current liabilities	620	283
Growth	119%			119%
D&A	323	139	78
% of revenues	9%	7%	10%	9%
Net fixed assets	1475	547	148
% of revenues	40%	28%	19%	29%
		1	2	3	4	5	6	7	8
	2011	2012	2013	2014	2015	2016	2017	2018	TV
Revenue	3,711	4,379	5,167	6,097	7,195	8,490	8,914	9,360	9,828
growth		18%	18%	18%	18%	18%	5%	5%	5%
Total costs and expenses	1,955	2,433	2,871	3,388	3,997	4,717	4,953	5,201	5,461
%		56%	56%	56%	56%	56%	56%	56%	56%
EBIT	1,756	1,946	2,296	2,710	3,197	3,773	3,961	4,160	4,368
Tax rate		45%	45%	45%	45%	45%	45%	45%	45%
Tax		876	1,033	1,219	1,439	1,698	1,783	1,872	1,965
NOPAT		1,070	1,263	1,490	1,759	2,075	2,179	2,288	2,402
Operating current assets	696	1,051	1,586	2,395	3,616	5,459	8,243	12,444	18,788
Operating current liabilities	620	936	1,413	2,134	3,221	4,863	7,342	11,085	16,736
NOWC	76	115	173	262	395	596	900	1,359	2,052
Change in NOWC		-39	-58	-88	-133	-201	-304	-459	-693
Net fixed assets	1,475	1,263	1,490	1,758	2,075	2,448	2,570	2,699	2,834
Change in NFA		212	-227	-268	-316	-373	-122	-129	-135
D&A	323	376	444	524	618	730	766	804	845
Capital expenditure		589	217	256	302	356	644	676	710
Free cash flow		1,620	1,421	1,658	1,927	2,230	2,519	2,505	2,419
Present value of FCF		1,385	1,038	1,035	1,028	1,017	982	835
Horizon value									14,231
PV of Horizon Value		4052.6
Total firm value									11,373
LT Debt on Balance sheet		398.0
Preferred stock		615.0
Equity value		3039.6
Common shares outstanding in 2012 IPO		388.0
Share price (Intrinsic value)		7.8
Price of IPO		38.0
Premium to intrinsic value		385%
Rating		Sell
WACC calculation
Google's WACC	9.50%
Premium for Facebook	7.50%
Facebook WACC	17.00%