Valuation of FAANG Stocks

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Capital Budgeting and Stock Valuation Assignment

Word count: 2545

Business are faced with capital budgeting decisions daily. Many of these decisions will either enhance or detract from the competitive position of the firm. Firms must often decide between many mutually exclusive projects as capital is limited. Due to the limitation of capital, businesses engaged in the capital budgeting process to ensure that only the highest NPV projects are selected. Not only does the capital budget process allows companies to ensure they create value for shareholders, it also limits the downside of having a project significantly harm the company (Allen, 1960). This is critical in capital intensive industries such as airlines or railroads. Here capital budgeting is critical as they must invest large sums of money but are not assured of commensurate returns. By being conservative in their capital budgeting process, these capital-intensive firms can be adequately compensated for the risks that they take in the market. For example, railroads must decide if they would like to invest to expand they’re into markets. In order to arrive at an adequate decision, the finance team must determine the amount of profit this new market will generate relative to the cost of entering the market. They must also take into maintenance capex and its implications on future profitability. The same concepts apply to airlines as well. The current pandemic is shedding light on an unforeseen black swan event can have grave consequences for firms that may not have used the capital budgeting process conservatively. Particularly, with the airlines, purchases of aircraft cannot be undone once delivered to the company. As we are currently realizing, there is a large oversupply of seat capacity in the industry due to low demand. This is ultimately putting pricing pressure on the industry with extensive cost cuts, furloughs, layoffs and reduced airfares throughout. Capital Budgeting is simply the ability to profitable and rationally allocate capital. Here, an outlay of capital is justified only when the NPV is positive (Anderson, 1963). A negative NPV project indicates a destruction in value and should therefore not be undertaken. The IRR is the internal rate of return that creates an NPV of 0. The payback period indicates the amount of time needed to recover the initial cost of the investment. It is calculated as the cost of the investment divided by the annual cash flows. The profitability index rule is a decision-making exercise that helps evaluate whether to proceed with a project. The index itself is a calculation of the potential profit of the proposed project (Bouwman,1987). The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed. A profitability index or ratio below 1 indicates that the project should be abandoned. NPV is superior return metric because it can be used when cashflows are uneven. It can also be used when determining mutually exclusive projects. As the discount rate increases, the NPV declines. Higher discount rates, as it relates to the sensitivity analysis increase the hurdle rate in which the project must clear in order to justify investment (Ahadiat,1990).

Table 1: NPV Calculation

Table 2: Sensitivity Analysis

Table 3: Relative Valuation (Source: Morningstar.com)

Facebook

Amazon

Apple

Netflix

Google

Average

Valuation

Price to Book

Price to Sales

Price to Cash Flow

Price to Earnings

Growth (3 year Annualized)

Revenue Growth

Operating Income %

Net Income %

Diluted EPS%

Financial Health

Quick Ratio

Current Ratio

Interest Coverage

Debt/Equity

Profitability

Return on Assets

Return on Equity

Return on Invested Capital

Net Margin

Comparable Method

The comparable method was chosen given the similarities between many of these businesses. Although each have very different and distinct business models, each of FAANG stocks are characterized as technology. Due to this they have very similar characteristics that warrant use of the comparable method. Namely, each of these stocks generate very high returns on capital. Each of them earns high returns on equity. They each have very strong competitive positions with economic moats that are difficult for competitors to match. They each have very revenue growth rates and require very little physical capital to generate their revenue. Finally, the each have strong cash flow generation capabilities. As a result, the occupy a unique niche within the technology space.

The primary assumption when using the comparable method is that the FAANG stocks will continue to grow at or better than the rates listed above. Here this assumption is justified for Facebook, Amazon, Apple and Google. For Netflix I believe growth assumptions will need to be adjusted down as discussed later in the report. The other primary assumption is that investors will value this growth in the future the same way they do today. This assumption may not hold in the future as investors are very optimistic about the prospects of these businesses. Investors may not be as optimistic about these companies in the future and therefore lower the value they attribute to their cash flow and earnings. Currently investor sentiment is high for these stocks as the world continues to handle COVID-19 (Reinicke, 2020). COVID-19 appears to further may of the technology trends that were just beginning. Firms are automating faster, customers are now heavily utilizing home technology for school and work, and more consumers are now shopping online. Due to these trends’ investors are much more optimistic about the prospects of the FAANG stocks as indicated by their higher P/E, P/B and P/S ratios. This optimism as we many other elements of a business cycle can be altered due to unforeseen developments in the market. As a result, this overall assumption may not hold as sentiment can quickly change over the next few years.

Even with the similarities the value of comparable needs to be adjusted to account for varying business models. For instance, Apple has a much lower growth rate than the other stocks in the portfolio. It is a much more stable and mature business than the others. As a result, its capital allocation strategy is different. For example, Apple is the only one of the FAANG stocks that pays a dividend. It is also the most aggressive repurchase of its stock out of the group. The primarily differentiator here is that Apple generates substantial free cash flow that it does not have enough investment opportunities to use the entire amount. As a result, it gives the cash flow back to shareholders in the form of a dividend. The others in the group however are growing very rapidly and retain all their free cash flow in the business. In many respects, they use this cash flow to further grow and expand their market leading positions. Due to this valuation methods such as the dividend discount model or the Gordon growth model could not have been used for valuation purposes

When reviewing the results, it becomes apparent that each of the FAANG stocks have high values based on commonly used metrics as Price to Book, Price to Earnings and so forth. Book value in this instance is not a relevant metric to evaluate each of these stocks as most of their assets are intangible and are very difficult to value from the asset side. From the liability side, most of these companies have very little debt as seen in their very low debt to equity ratios. As a result, the Price to Book values appear to be somewhat misleading. Price to Cash Flow however is a very relevant metric and it appears that 4 of the 5 stocks trades with a similar range of Price to Cash Flow. The outlier being Netflix which has very high price to cash flow ratio. This may indicate that investors are overly optimistic regarding the very cash flows of Netflix relative to the over FAANG stocks. This over optimism may also indicate that the stock is overvalued as cash flow growth will need to be substantial in order to justify the higher ratio. The business model of Netflix however does not seem to lend itself to higher cash flow growth then a Google, Facebook, or Amazon. In the latter’s case, they must invest heavily in content in order to maintain subscribers. Subscriber growth although growing fast, is not growing at the rate it did just 3 years ago. Projection for subscriber growth for the next 3 years are also limited per chart 2 below. The ability to raise prices will also be diminished the higher the price increases are. As a result, I believe the continually need for investment in programs and content combined with the limited subscriber growth and ability to raise prices will ultimately limit free cash flow growth.

Figure 1: Netflix Subscribers

Based on the comparable, I therefore believe Netflix to be overprices.

As it relates to the findings related to the FAANG stocks, my observation is that they are priced. The higher P/E ratios appear justified given the current low interest rate environment we are currently in. Low interest rates essentially inflate asset prices as investors discount future cash flows at lower rates. In addition, the capital markets line is lowered for all asset classes due to the low risk-free rate. As the capital markets line is lowered, investors must reach for yield in order to generate the same returns they would have otherwise generated in a higher interest rate environment. Due to this, investors are taking more risk and purchasing the FAANG stocks in higher quantities. The allocation towards equities bids the prices of these stocks higher. Currently the higher prices seem reasonable given the alternatives in the market today. Risk free rates around the world are zero, high quality corporate bonds are yielding 2% to 3%, and high yield bonds are roughly 4% to 6%. Investors. As show below due to the low rate environment all assets along the capital markets line are lowered. Due to this, the FAANG stocks appear reasonably priced as there is no other viable alternative that provides the same high returns as the FAANG stocks generate as a collective portfolio. Because of their market leasing positions, an even mix of each should be low risk for a longer-term investment.

Figure 2: Capital Markets Line.

The average P/E ratio of the group is 54.41, which is well above the historically average of the S&P 500 P/E ratio of 16 over the last 50 years. The higher P/E ratio is due to the extraordinary high growth rates for each company in the group noted in the chart above. As mentioned earlier, many of their companies do not pay a dividend and retain all their free cash flow within the business. The companies there benefit from compounded effect on their overall business valuation. First, each of the FAANG stocks earn extraordinarily high returns on invested capital. Second, the firms retain all their available cash flow within the business which grows at this high rate of return. If the company can maintain these high rates or return for prolonged periods, their overall business valuation will compound much faster than if they paid a portion of their cash flow out in dividends. These very high growth rates, low debt, and marketing leading positions is what contributes to the higher P/E multiple. However, this growth has not necessary translated into earnings. Investors are projecting high growth rates for the foreseeable future without necessarily considering the possibility of these earning not materializing. If this does not occur in the future the multiple investors attribute the FAANG stocks will be lowered and as such, so will their stock prices.

To account for the possibility of growth not being generated in the many that current market investors forecast, the firm should sell Netflix stock. As noted above, the stock appears grossly overvalued on a comparable basis. It does not have as strong of an economic moat as the other firms within the portfolio. Netflix for example, is being challenged by Disney, HBO, and Amazon. It also has indirect competition form YouTube and even video game companies who are all vying for increased share of a customer’s leisure time. Its subscription business model has limited growth prospects and price increases are not sustainable over the long term. The business must continually invest in content in order to retain subscribers which ultimately lowers free cash flow generation capabilities. The switching costs are also very easy for consumers. The ease of switching combined with pending price increases and large amounts of competition gives consumers too much power. As such, a large exodus of consumers can easily leave the company scrambling to create more content to retain customers, which ultimately lowers cash flow further. The other firms in the portfolio have much better market positions. Each of their businesses are very “sticky” with few viable alternatives. For example, Amazon cloud computing franchise is very sticky with business customers are very difficult to switch without causing the business disruption. The Apple ecosystem gets stronger with each device a person owns. Its customers are loyal and are often willing to pay premium prices for its products and use of the ecosystem. Google search is the only viable option as other engines are simply not as good. Facebook social media platforms are very difficult to displace and replicate. Netflix does have certain advantages in terms of exclusive content, but the company must continually pay for this content at higher amounts. Finally, as it relates to Netflix, the stock is priced for perfection and anything less than this will cause the price to decline very dramatically. Of all the peer companies, Netflix has the second highest Price to Book, the second highest Price to Sales, the highest Price to Cash Flow, and the second higher Price to Earning. Essentially, the numerator of the ratio is too high, and investors are assuming higher growth rates to justify the higher ratios. For the reasons mentioned above, there is serious concern as to companies’ ability to generate and maintain these higher growth rates in the future. If these don’t materialize investor expectations must therefore decline and so too will the price (Pressman,1998).