3 Reasons to Be Skeptical About Facebook, Inc.'s Valuation

Facebook stock's 140% rise in the past two years has been great for investors who already own the stock. But for those considering buying after the rise, is it really possible to justify the social network's $260 billion valuation?

Facebook app. Image source: Facebook.

Does Facebook's business live up to its hyped stock price?In Facebook's most recent quarter, the company reported $4 billion in revenue. This would put its annualized run rate for revenue at about $16 billion. For most companies, $16 billion in annual revenue wouldn't be close to enough to justify a $260 billion market capitalization -- even if its business model has potential to eventually sport a 60%-plus operating margin.

So, what separates Facebook from "most companies"? Growth. Once investors consider how fast Facebook's revenue is growing, the valuation looks a little more interesting (but still pricey). In the company's most recent quarter, Facebook's revenue grew 48%, year over year.

Still, even with its soaring top line, investors should be cautious about the social network's valuation. Consider these three recent trends in its underlying business that could signal headwinds for the stock.

1. Rising operating expenses.Growth doesn't come cheap. And investors saw evidence of this in the company's second-quarter results. GAAP operating expenses jumped 82% year over year. This jump in operating expenses pressured Facebook's operating margin, reducing it to 31% -- down from 48% in the year-ago quarter. Its non-GAAP operating margin, which excludes the significant impacts of stock-based compensation related to its WhatsApp acquisition, was 55% -- down from 60% in the year-ago quarter.

The rise in GAAP and non-GAAP operating expenses as a percentage of revenue was due primarily to an increase in employee headcount and stock-based compensation related to its WhatsApp acquisition, respectively. Both of these reasons for higher operating expenses are representative of the types of costs Facebook investors should become familiar with; the company's chase for rapid revenue growth will require lots of up-front spending.

For the rest of the year, Facebook continues to expect its operating expenses to increase faster than revenue.

2. Rapidly decelerating revenue growth. One area that investors may be overlooking is the company's decelerating revenue growth. While it has always been clear that 70% plus year-over-year growth in its advertising revenue achieved at the end of 2013 and the beginning of 2014 wouldn't be sustainable, some investors may not have expected the deceleration since then to be as rapid as it has been. And even in Facebook's most recent quarters, this brisk deceleration continues.

Data for chart retrieved from respective quarterly Facebook SEC filings. Chart source: Author.

3. A disappearing catalyst. One of the key catalysts for Facebook stock's rise since it went public in 2012 has been a transition to mobile. Facebook didn't just surpass expectations when it came to monetizing mobile -- it crushed them. Indeed, its mobile news feed ads set a standard for nearly every mobile social network to follow. With mobile advertisements for Facebook turning out to be more effective than desktop ads on its platform, marketers (along with a meaningful chunk of their marketing budgets) flocked to the blue app to get a piece of the action.

But this catalyst is disappearing. When the company went public, zero percent of its advertising revenue came from mobile. Today, mobile accounts for 76% of ad revenue.

Data for chart retrieved from respective quarterly Facebook SEC filings. Chart source: Author.

Yes, mobile revenue will undoubtedly continue to grow rapidly as advertisers continue to increase their budgets for mobile advertising. But the incremental revenue coming from advertisers shifting their digital advertising budgets over from desktop to mobile is set to become a smaller driver for Facebook's ad revenue growth.

Investors should think twice before buying Facebook stock at these levels.

The article 3 Reasons to Be Skeptical About Facebook, Inc.'s Valuation originally appeared on Fool.com.

Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Facebook. 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.