Why Facebook Stock Is Riskier Than You Think

By Markets Fool.com

What a reversal Facebook shares have seen during the social network's relatively short life as a public company! In the wake its controversial May 2012 IPO, the stock was reviled. However, in July 2013, the company published quarterly results that indicated its transition to a mobile platform was well on track and the love affair with investors was back on, and shares have more than doubled since then. But while Facebook's rise may appear inevitable, three of our contributors suggest the stock might be riskier than you think:

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: As someone who has left Facebook, I'm aware that it is possible to do without it. I'm also aware that I'm in a very small minority -- the service is sticky. My problem isn't with the business -- which appears to be in good health, with what looks like an ever-widening competitive moat -- but with the shares themselves, and, more specifically, their valuation.

Indeed, Facebook is currently changing hands at a forward price-to-earnings ratio of 33.1, per research service Morningstar. The comparison I always come back to is Google -- the single most comparable company -- which trades at roughly half that multiple (17.1). I understand that Facebook may be earlier in its growth path than Google, but, at $232 billion, its market value is close to two-thirds that of the search behemoth.

To reiterate, Facebook is a great business. I don't think investors will necessarily lose money on the stock from these levels (assuming an equity-appropriate holding period). However, due to the valuation, this looks like a case of "terrific business, middling stock" -- investors could well end up flat-footed by the pedestrian returns this dominant technology name generates over the next several years.

: In Facebook's short history, the company has made some truly massive acquisitions. In 2012, Facebook paid $1 billion for Instagram, a photo-sharing app that has continued to grow its user base relentlessly since being acquired. Two years later, Facebook paid a mind-boggling $19 billion for WhatsApp, a mobile instant messaging company with almost no revenue at all.

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While there's an argument that these acquisitions were strategic, there's a trend here. Instagram was a threat to Facebook, drawing users away, and the only solution was to buy the company outright. WhatsApp was a competitor to Facebook's own messaging service, boasting far more users at the time of the acquisition. Facebook now runs both services independently.

One of the biggest risks for Facebook going forward is the rapid rise of apps and services that draw users away from the platform. Snapchat, which now boasts close to 200 million mostly young users, is a great example of this. Facebook attempted to acquire Snapchat in 2013 for $3 billion, only to be turned down. It then built its own ephemeral communication app, Slingshot, which failed to gain much traction. Snapchat now has a $15 billion valuation based on its most recent fund-raising efforts.

The worst case scenario is that Facebook is forced to continually acquire popular apps and services for billions of dollars each in order to prevent users from abandoning the platform. Facebook is profitable, but not profitable enough to keep shelling out tens of billions of dollars for companies with little revenue to speak of. These acquisitions also put a truly massive amount of goodwill on the balance sheet, creating a time bomb that could tank future earnings if things don't go exactly to plan.

Tim Brugger:The day before announcing fiscal 2014 annual and Q4 earnings, Facebook stock was trading at $75.78 a share. By the close of business on Fri, March 27, Facebook stock was up 10% at $83.30 since its earnings announcement. And certainly there's a lot to like, as sales jumped 58% last year compared to 2013 and Facebook CEO Mark Zuckerberg's laser-like focus on mobile continues to pay dividends and now accounts for nearly 70% of ad revenues.

Perhaps overlooked by some Facebook investors amid all the positives was one possibly disturbing trend: spending is skyrocketing. Facebook CFO Dave Wehner warned the Street ahead of last quarter's call that expenses would rise as much as 70% due to infrastructure costs, R&D, including testing video ads, and new measurement tools, along with assimilating acquisitions. Turns out, Wehner was overly conservative. Last quarter costs soared by 87%, dropping Facebook's operating margin to 29% from 2013's Q4 margin of 44%. On a GAAP basis (including one-time costs) Facebook generated $1.13 billion of income in 2014's fourth quarter, identical to 2013's results.

As eye-opening as Facebook's overhead has become, Wehner said that expenses would continue to climb, as much as 50% to 75% above what are already inflated spending levels. Make no mistake, it takes spending to fuel growth, and Facebook is certainly growing. But the dramatic increase in costs warrants monitoring by Facebook investors to ensure they see a return on all those investments. Because if there's not, or it takes too long to see tangible results, Facebook's stock will be pressured.

The article Why Facebook Stock Is Riskier Than You Think originally appeared on Fool.com.

Alex Dumortier, CFA has no position in any stocks mentioned. The Motley Fool recommends Facebook, Google (A shares), and Google (C shares). The Motley Fool owns shares of Facebook, Google (A shares), and Google (C shares). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.