In our investment process, we start by looking at a company through quantitative analysis – that means looking at the numbers. The reason we do this first is because it saves time. If the numbers are bad, there’s no reason to spend more time on the company.

The quantitative analysis also helps to reveal problems and surface questions. Then when you dig into the qualitative information, you know what you are looking for.

What did I uncover about Meta?

Meta is a brilliant company. I say its brilliant because I assign an intrinsic value creation score to companies and Meta scores 182. This score is relative to other companies. Below is a list of fabulous companies - look at how much more intrinsic value Meta created. But hold your horses before rushing to buy the stock – read all the way to the end.

There is no reason to believe that Meta cannot continue creating value, so why not just buy the stock? 

Profit margins

The first investment paradox that we face is profit margins. What I mean by paradox is that you find a brilliant company, but then you also discover things that concern you.

In this case, the thing that concerns me is declining profit margins. Meta’s profit margins started at 20% (2013), then peaked at 38% (2018), then dropped to 23% (2022) and has now recovered to 30% (2023).

We know that a few years ago Mark Zuckerburg (CEO and founder, also known as Zuck), went big developing the metaverse concept. The metaverse is a virtual world where you can own virtual land and interact with people while wearing virtual reality goggles. That didn’t work out as planned so Meta cut costs (i.e. fired a lot of people).

That might explain the 2022 drop in profit margins and the subsequent increase in 2023. But the margins are not yet back to the 2021 level of 33%.

The problem is that there has been an increase in Meta’s cost structure. A second problem is that they make less money per sale than before. Those two effects combine to reduce profit margins

We can conclude this discussion by saying that the quantitative analysis has revealed that we have to understand what is going on with profit margins. Potential questions to ask in the qualitative analysis are:

• Have profit margins stabilized or can they increase?

• Will there be further cost reductions?

• What effect is competition having on margins?

Stock-based compensation

Stock-based compensation (SBC) is a company paying its staff with stock instead of in cash. Since no money changes hands, SBC seems cheap but is very costly to shareholders.

It saves cash in the short-term, but in the long-term it makes the compensation costs much higher, particularly in a great company like Meta.

I am not going to go into detail on SBC, because we already did a newsletter on it here. But think of the problem like this. 

Your company has 100 shares issued and you own all of them, that means you own 100% of the company (100/100 = 100%). Instead of paying your staff in cash, you pay them with 10 shares (i.e. stock-based compensation). Now you own 91% of the company (100/110 = 91%). In finance parlance, this is called dilution because your ownership gets diluted.

You can see the problem - the company is being given away bit-by-bit. That is why it is bad for shareholders. Normally it gets masked with share buybacks, but this is an expensive way to cure the problem.

Below is the SBC for Facebook (from our previous newsletter) and as you can see they hand out the equivalent of about one-third of it is free cash flow in SBC. That is an extremely high figure.

When it is handed out, it is not real cash flow, so the SBC number below is not an actual cash cost. The problem is when the company buys those shares back at a higher price in future, then it is a real cash cost. So, compensation costs a lot more than 31% of free cash flow in reality.

SBC is commonplace in US tech companies - always check what you are buying into.

What is odd about Meta, is that Zuck owns about 13% of the company and he controls it. Usually founder controlled businesses are more shareholder friendly. Perhaps consultants convinced Meta that SBC makes profits look better?

In concluding this section, it is important to understand why SBC is so high and to think through the effects on your investment. Interestingly, if the market turns downward, SBC will drop because everybody wants shares when they are going up, but nobody wants them when they are going down.

Conclusion

I hope this has given you food for thought on the paradoxes of analysing an investment. You can love some parts of an investment and hate other parts.

(I might do part two of this discussion if we end up buying Meta).

I would like to hear what you’re up to.

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