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Facebook – an IPO gone bad?

Published 7 years ago by BlackDigits

Published on the Times of Malta

Facebook is one of the largest companies to go public. It has more unique visitors than any other website and its total pages are viewed about 10 times the size of its next closest competitor. Not buying Facebook seemed like not buying Google when it was first floated.

So why did the price fall by 27 per cent within a month of going public?

Shares issued by US companies through an initial public offering are not offered directly to the public. At a very high level, companies that issue their shares to the public go through a process called a “road show”, a process which involves presentations made to institutional investors and among other things, the share price is determined according to feedback the company receives during the road show.

Facebook initially priced its shares between $26 and $35, but after encouraging feedback during the road show, it upped the price to between $34 and $38. The IPO price was finally agreed at $38, reflecting the huge demand for Facebook shares.

Institutional investors then sell their shares to the public on the day of the IPO. Accepting to pay $38 a share means they were confident the public was happy to buy at that price.

IPOs are generally under-priced for several reasons. For starters, the institutional investors want to ensure that they will not get stuck with unwanted shares. From the perspective of the company that issues the shares, under-pricing its IPO may leave some money on the table. This increases the likelihood that the price “pops up” on day one. This phenomenon is regarded as generating additional interest in the stock. Shares that perform badly immediately after the IPO damage the image of the company. Facebook is an excellent example.

The upward revisions in the price during the road show valued the company at $104 billion. Valuations are relative to expected earnings but since this information is not generally available, the total value of the company is expressed as a function of current earnings. Facebook reported $1 billion profit after tax in 2011 which means that investors were asked to pay $1 for every one cent of current earnings (a Price/Earnings ratio of 100 times).

This is clearly excessive but it is not uncommon in the context of start-up companies on the expectation that future earnings will grow exponentially.

A P/E ratio of an established company is in the region of 11 to 15: the P/E ratio of an innovative, fast-growing company like Apple Inc currently has a P/E ratio of around 14. This means that ignoring the time value of money the institutional investors who accepted to pay $38 a share expected earnings of Facebook to be roughly $7 billion in the long term – $104 billion divided by a P/E ratio of 14.

It is clear the main reason behind the fall in the share price is that the public was not confident in these aggressive earnings expectations.

Why was the market less bullish about the expected earnings? The core driver of the business is advertising dollars. Google reported $37 billion in revenue in 2011, a 29 per cent growth on the previous year. Facebook reported just $3.7 billion in revenue in 2011, possibly an indication that the social media giant has a huge and growing potential. Perhaps the $38 per share valuation might seem reasonable after all.

Google boasts it is able to show adverts connected to searches run by users and it claims that this makes its advertising space effective. Facebook also has a sophisticated mechanism on collecting advertising revenue – it is even capable of converting some likes posted by users in relation to commercial products into advertising dollars.

But there seems to be some uncertainty on Facebook’s potential to substantially increase its revenues. According to the Motley Fool, a website dedicated to investments, people only click on one in every 2,000 Facebook ads.

The prospectus mentioned a continuing trend in the number of daily users increasing more rapidly than the rise in ad revenue – the advertising revenue per user is decreasing.

Facebook has a healthy balance sheet: its leverage is relatively low, around 60 per cent of its assets are made up of cash and US government debt and it clearly has a unique product with a huge user base. But it needs to overcome its challenges relating to revenue generation. It is probably this uncertainty that drove investors away from taking the plunge and buy at such a high P/E ratio.

The substantial drop in share price is a clear message passed by the market to the institutional investors: “Facebook is a good investment but you tried to hype up the stock with the hope that the public will buy on the expectation of selling at a higher price. Thanks but no thanks – you can keep the stock”.

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