Google, Facebook, Twitter: Not Enough Dollars to Go Around; Given the size of the ad market, it will be nearly impossible for dot-coms to all grow into their market values

SATURDAY, MARCH 29, 2014

Google, Facebook, Twitter: Not Enough Dollars to Go Around

By JACK HOUGH | MORE ARTICLES BY AUTHOR

Given the size of the ad market, it will be nearly impossible for dot-coms to all grow into their market values.

GoogleFacebookTwitter, and a slew of other high-flying dot-coms are headed for a pie problem. Viewed individually, each seems to have endless potential to turn popular, free services into more revenue by grabbing a larger slice of the online advertising pie. But as a whole, online ad spending is growing at a fairly predictable pace, and won’t be large enough anytime soon to justify all of the high-flying valuations on dot-com shares.

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Forget for a moment about whether, say, Facebook (ticker: FB) is worth 63 times projected 2014 earnings (or 48 times if we use Wall Street’s preferred earnings measure, which ignores the cost of paying workers with stock). Instead, calculate a value for a theoretical company that captures all of online ad spending. Even with generous assumptions, such a company would be well smaller than the recent collective value of just a dozen dot-com companies that together control 81% of online spending, according to a recent analysis by Janney Capital Markets, an investment bank.

Over the long term, total ad spending has more to do with total wealth than with how people view or hear ads—a relationship academics call the principle of relative constancy. Simply put, people only buy so much stuff, and companies only devote so much of their budgets to convincing people to buy. Next year the world will spend about $560 billion on advertising, and Internet advertising will grow 14%, to $132 billion, predicts ZenithOptimedia, a market researcher. Suppose it has estimated too low, and Internet ad spending accelerates (which it hasn’t done in years) to 16% growth, hitting $134 billion.

HOW MUCH WOULD A company that controls all of that spending be worth? Price/earnings ratios for dot-coms are all over the map, but another measure is more consistent from company to company: price/sales-growth ratios, or market value divided by sales, divided by the rate at which sales are growing. Based on 2015 projections, Google (GOOG) has a P/SG ratio of 0.31, Facebook 0.37, and Twitter 0.29, according to Janney analyst Tony Wible. The average among seven big ad-driven dot-coms, the aforementioned three plus AOL (AOL), Yahoo! (YHOO), LinkedIn (LNKD), and Yelp (YELP), is 0.29.

Take Google’s premium P/SG of 0.31 and apply it to the optimistic assumption for the online advertising pie, 16% growth next year to $134 billion. The result is a $665 billion value for a company that gobbles the whole pie. But the top dozen companies by share of online ad spending recently fetched a collective $724 billion, after subtracting Yahoo’s planned Alibaba sale and Tencent‘s (0700.Hong Kong) non-ad business. The analysis doesn’t factor in the ability of these companies to create meaningful future revenue streams based on, say, payment fees rather than advertising. But it also understates the market value of the group, because it only looks at the top dozen names, and it assumes no big new competitors will emerge.

The numbers suggest, to say the least, that many dot-com companies will struggle to live up to the market share expectations implied by their stock prices. Google, Facebook and Twitter (TWTR) will control an estimated 51%, 11% and 1% of next year’s online ad spending. By Wible’s reckoning, they must grow those shares to a mathematically impossible 74%, 32%, and 6%.

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These dozen companies control 81% of online advertising, projected to total $132 billion next year.

Company / Ticker Market
Value (bil)
2014E
P/E
Share of Online Ad Revenue
Google / GOOG $377.1 25 51%
Facebook / FB 152.4 63 11
Tencent / 0700-Hong Kong 128.6 39 2
Baidu / BIDU 52.8 29 9
Yahoo / YHOO 36.2 28 4
Twitter / TWTR 26.8 N.M. 1
LinkedIn / LNKD 22.7 N.M. 1
Yelp / YELP 5.4 N.M. 0
Zynga / ZNGA 3.9 N.M. 0
AOL / AOL 3.4 25 1
Sohu.com / SOHU 2.5 N.M. 1
Renren / RENN 1.3 N.M. 0
Data as of March 28. E=Estimate. N.M.=Not Meaningful.
Sources: Bloomberg; Factset; Janney Capital Markets

The group may still produce winners from here. Facebook stock, up 130% over the past year, carries a Buy recommendation from 37 of the 46 analysts who cover it—and no Sells. Chris Baggini, manager of the Turner Titan fund, likes Facebook in part because its earnings expectations have been rising in tandem with the stock price, but he doesn’t like Twitter, whose growth prospects he views as “more finite.” And of course, short-term stock performance is more closely tied to sentiment than fundamentals. Wible expects valuations to continue to be stretched from here because there’s “no major catalyst for revision.”

LONG-TERM INVESTORS should use caution, however. A separate piece of analysis shows how frothy things have gotten among stock market darlings. The Standard & Poor’s 500 index recently traded at 17 times trailing earnings, versus a historical average of around 15, suggesting it’s fully priced but not extraordinarily expensive. But the difference between the P/E ratios of cheap stocks and expensive stocks is the widest it has been in 13 years, according to an analysis provided by AllianceBernstein. “The cheap stocks are at their usual level of cheapness,” says Gerry Paul, a portfolio manager for the firm. “But the expensive stocks are the priciest they’ve been since the first dot-com stock bubble.” He favors legacy tech names with humble valuations, like Hewlett-Packard (HPQ) at nine times 2014 earnings, and mature businesses like Ford Motor (F) at 11 times 2014 earnings.

Stocks like those aren’t exactly buzzy. Ford’s next pick-up truck looks cool, but not as cool as the virtual reality headset developer that Facebook this past week paid $2 billion for, mostly with stock. Then again, studies show that when the spread between cheap and expensive stocks is wide, as now, value stocks tend shine going forward and glamour stocks tend to struggle. Bet on financial reality to trump virtual reality this time, too.

 

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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