By Mark Hulbert
In which industry does Facebook /zigman2/quotes/205064656/composite FB +1.18% belong? The answer is more than academic. If Facebook is a technology company, then it’s undervalued relative to other companies in that industry. If it’s a media company, then it’s overvalued compared to its peers.
This debate over Facebook’s industry has been largely cast in political and legal terms. If the company is not a media company, then it perhaps could sidestep many of the strict advertising and content regulations that apply to such companies.
But relative valuation is also a factor. So long as Facebook can be considered a technology company, as its executives often insist, then its stock would appear to be significantly undervalued. That’s a convenient ancillary benefit of the political and legal argument.
The table below provides some comparative valuation statistics, courtesy of FactSet. The Communication Services SPDR /zigman2/quotes/204079482/composite XLC +0.26% is benchmarked to an index of companies from “telecommunication services, media, entertainment and interactive media & services.” The Vanguard Information Technology ETF /zigman2/quotes/207654339/composite VGT +0.16% , in contrast, invests in companies in the “electronics and computer industries or that manufacture products based on the latest applied science.”
|P/E ratio (Last 12 months EPS)||P/Book Ratio|
|Communications Services SPDR||25.7||4.1|
|Vanguard Information Technology ETF||35.7||10.1|
|Invesco QQQ Trust /zigman2/quotes/208575548/composite QQQ||33.8||8.6|
You might think this debate over Facebook’s industry classification was settled some time ago. Because almost all of the company’s revenue comes from advertising (98%, according to FactSet), it may seem obvious that it has more in common with the media industry in general, and advertising and marketing companies in particular, than with companies in the information technology sector.
In 2018, in fact, the Global Industry Classification Standard (GICS) reclassified a number of companies that previously had been part of the Information Technology category, including Facebook. That’s when the company was added to a newly created category called Communication Services and, as you can see from the table, Facebook has a higher P/E and P/Book ratio than that overall category.
But old habits die hard. For example, MarketWatch’s most recent quarterly review of Facebook’s valuation refers to the company as a “tech” stock, and compares it to the “tech-heavy Nasdaq Composite Index /zigman2/quotes/210598365/realtime COMP -0.30% .” In that context, Facebook comes out looking undervalued.
Another example: FactSet lists Microsoft /zigman2/quotes/207732364/composite MSFT -0.23% at the top of the list of Facebook’s comparable companies, even though advertising represents a far smaller percentage of Microsoft’s revenue. Facebook’s P/E and Price/Book ratios are each significantly lower than Microsoft’s.
Why classification matters
You might wonder why classification matters. After all, Facebook’s profitability will be the same in coming years regardless of its industry categorization or the companies deemed to be its peers.
It matters because industry classification affects the valuation multiples that investors are willing to pay for a stock. Researchers have found that, upon getting moved from one industry to another, a company becomes less correlated with companies in its previous industry and more correlated with those in the new industry. These changes in correlation have nothing to do with the company’s fundamentals, of course.
The most spectacular illustration of this came at the top of the internet bubble, when many companies changed their names to include “dot-com” but otherwise made no changes to their business models. One study found that these changes, on average, led to a 74% increase in those companies’ stocks. That’s a near doubling for no other reason than being deemed to be a part of a different industry.