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Did Facebook Just Go on Sale?

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After reporting disappointing quarterly earnings and lowering guidance, Facebook (FB - Free Report) shares are down nearly 20% from Wednesday’s close, wiping out a staggering $100 billion in market capitalization – the biggest single day decline in history.

The capitalization-weighted NASDAQ index is off 1% due mostly to the Facebook decline. The price-weighted Dow Jones Industrial Average – which does not include Facebook - is up 0.5%.

The knee-jerk reaction for some investors will be to see the decline in Facebook as a buying opportunity – a chance to pick up the stock at a significant discount to where the market was pricing it just 24 hours ago. Others will see it as a catastrophe – a sign that the spectacular growth the company has seen is finally slowing permanently.

A closer look at the numbers reveals that the truth is probably somewhere in the middle.

The net earnings number was $1.74/share, missing the Zacks Consensus estimate by just one penny. The revenues came in at $13.23B, under the expectation of $13.34B but hardly a disaster. Both numbers were significant increases over the same quarter last year, with revenues up 42% over 2017 and net income up 32%. Daily and Monthly average users – always an important metric for Facebook - both increased 11%.

It was the company’s guidance that has prompted the historic selloff, with Facebook lowering expectations for revenue growth in Q3 and beyond. The company indicated that changes in user behavior specifically related to privacy concerns would make it more difficult to monetize advertising content.

The Bigger They are, The Harder They Fall

Facebook shares had come a long way in 2018, recovering from the Cambridge Analytica scandal earlier in the year and staging an impressive 42% rally since hitting a 52-week low in March. Even after today’s decline, the shares are basically unchanged on the year and 15% above the March lows.

It’s a classic case of investor expectations getting in front of reality and leaving the company a razor thin margin of error. It was specifically because Facebook had come so far so fast that a selloff like today’s was even possible.

Why the Massive Market Reaction is Actually Very Rational

On a valuation basis, Facebook has actually not changed much over the past day. Facebook had been priced for continuing earnings growth with a forward P/E ratio of 26X. Accounting for revised earnings expectations, that valuation is basically unchanged. The price to sales ratio based on lowered expectations is also roughly the same at 14X.

Facebook shares are widely held by institutions, so the rational and quantitative reaction to the lowered guidance figures is not totally unexpected. Professional money managers pay for earnings. When the earnings outlook changes, they unemotionally change their valuations of the stock. Today’s action in Facebook is not a panic sell, it’s simply the logical revaluation of those future expectations. The stock found a new level and has basically stayed there all day.

The price movement in the broad indexes is limited to the actual impact of Facebook - other stocks are relatively unaffected.

Does the Party Have to End?

Facebook remains the world’s biggest social media platform and holds a dominant position in online advertising, especially mobile ads. They are still growing revenues and the number of users, albeit at a somewhat slower rate than in the recent past. The company is clearly not going anywhere, and it’s not difficult to imagine a future where their dominant market share equates to slow, steady earnings growth and their huge free cash flow pays for a healthy dividend. Picture Microsoft (MSFT - Free Report) over the past 15 years or so.

Though the raw numbers are eye-popping, today’s selloff in Facebook is really evidence that the markets actually work quite well. Companies grow up, expectations change and the markets adjust accordingly. If you liked Facebook yesterday at $217/share, when you consider the new information, not all that much has changed.

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