Meta is a giant enterprise that behaves like a penny stock. 

In September 2021 it was worth close to a trillion dollars — $985 billion. The following November it was worth $228 billion, a drop of 77 per cent.That’s not meant to happen to companies with 86,000 employees. In 13 months, Meta lost more value than the combined value of every company on the Italian stock exchange. 

Since November, Meta has zoomed right back. The share is up 114 per cent in the last three months. 

On the morning of the release of its Q4 earnings last week, the share rallied by an astonishing 24 per cent. $95 billion of value was created in one day, based on one set of quarterly numbers. 

So, what the devil is going on with Meta’s share price? 

I built a valuation model to find out. 

The model

My valuation spreadsheet, built in an afternoon, is a toy version of the real thing. It has five inputs: operating profit, tax, change in working capital, change of capital expenditure (or capex), and cost of capital. That’s it. But between them, you can get a sense of what’s causing Meta’s share price gyrations.

The idea is that you use the first four numbers to come up with a number for free cash flow. Once you have that, you divide it by the cost of capital to get the valuation.

In Meta’s case, the three most important ones are profits, capex, and cost of capital. By fiddling with those three knobs, you can start to see what’s been happening with Meta’s share price. 

Operating profits don’t need much explanation. 

Capex is money spent buying and maintaining assets. Working capital is money spent building inventories and the like. Capex and working capital are both forms of investment. They matter to the valuation because they stand between the shareholder and their cash flows — the shareholder only gets what’s left over after the company has made the required investments. 

Working capital is one of these obscure business concepts that turn out to be very important to a company’s value. Companies that don’t have to spend lots of money upfront to grow sales are worth more than those that do. Amazon does; Meta does not.

Strictly speaking, capital expenditure is investment in tangible assets like buildings, machines and computers. But I’ve broadened it out to include “spending on stuff in the present, to increase profits in future”. The definitional expansion was needed because a lot of the investment Meta is making — in the Metaverse, for example — doesn’t fit the traditional definition of capex. Intuitively it feels like capex to me, and it’s my model, so I’m calling it capex.

The last one is the cost of capital. This is the return investors expect for investing in Meta. There’s a formula for calculating it, which I won’t get into, but the three ingredients are the risk-free rate, the expected return in the market, and the degree to which the internet software industry is riskier than the overall market. 

The upshot of the cost of capital formula is, the higher the cost of capital, the riskier investors think the company is, and the more return they demand, and conversely, the less they’ll value each dollar of cash flow in the here and now.

So that’s how the toy valuation model roughly works. What changed so that Meta went from being worth $985 billion in 2021 to $228 billion in 2022 to $400 last Wednesday to $495 billion last Thursday?

Three shocks 

Since September 2021, three big things changed for Meta.

The first one was that the pandemic caught everyone unaware. During the pandemic, spending on e-commerce went through the roof for about 18 months. Meta’s managers and its investors weren’t sure what to make of it. Their interpretation was that the pandemic had dragged the future forward by a few years. The managers responded by hiring like crazy and the investors responded by bidding up the share price. 

But they were wrong — the pandemic hadn't shifted the trajectory of e-commerce or moved it onto a higher trend line. Once the pandemic ended, sales dropped right back to the long-term trend, which is where they are now. 

On the valuation model, there's a big difference between 20 per cent growth and 25 per cent growth. And there's a big difference between 20 per cent growth from the 2019 level and 20 per cent growth from the 2021 level. This was the first and most important shock to Meta's share price.

The second shock came from the macroeconomy. When inflation rose last year the Federal Reserve had to raise interest rates. This drove up the risk-free rate, which drove up Meta's cost of capital, and drove down its valuation. In my model, Meta's cost of capital went up from 8.5 per cent to 11.5 per cent.

The third shock came from Meta's investment plans. In October 2021, which turned out to be a couple of weeks after Meta's high point, Zuckerberg announced he was going all-in on the metaverse. It invested $19 billion in 2022 and, according to The Information, it's expected to invest $70 billion in total on the project. That's in addition to heavy investment in the computing power needed to train AI models, and all its other capex. 

The increase in the reinvestment rate was, itself, bad because it meant less cash left over for shareholders. But I suspect it was also bad because it told the market that Zuckerberg, the supreme overlord of Meta, wasn't particularly fussy about shareholder value. A Zuckerberg that was willing to burn $70 billion on his metaverse project is a Zuckerberg that might burn a further $70 billion on something else in five years.

I suspect that's part of the reason why the share responded so strongly to Q4 earnings last week. Zuckerberg cut capital spending, which is itself good. But it's also a demonstration that he listens to shareholders and cares about what they want. The $40 billion stock buyback announced last week drove the point home. 

Fiddling with the inputs into this model, what struck me is how resilient Meta's business is. When you strip back extraneous stuff like the cost of capital and Zuckerberg's metaverse scheme, what's clear is that underneath it all, Meta still generates monstrous operating profits year in and year out. Even without the pandemic bump, Meta had been growing profits at an insane pace — 35 per cent per year between 2013 and 2019. Though its revenue is flattening out, it still has levers to pull when it comes to increasing profits in the coming years.

I suppose that helps explain the volatility. Meta has so much potential that the difference between a well-run and a sloppily-run Meta is enormous.