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Who Likes Facebook Now?

Facebook's IPO reminds us that business valuation principles apply even when a company has 900 million friends.

On the morning of May 18, investors snapped up Facebook shares at prices ranging from the initial public offering of $38 all the way to $45, despite technical problems that made it difficult to know how many shares they had purchased, and at what price.

Then the selling started. By last week, Facebook shares were trading below $27. About $30 billion had been trimmed from the company’s market value, which stood at $105 billion on IPO day. The same investors who had been so eager to buy less than two weeks earlier were, for the most part, either selling or asking themselves whether they should sell.

Word did emerge after the IPO that Facebook’s investment bankers had told favored clients – but not the general public – that the company’s prospects in certain markets, notably mobile advertising, did not look so good. This selective disclosure would be a crime in almost any other securities context but, oddly, is permitted in connection with an initial offering. (We can safely assume that someone in Washington is working feverishly to close this particular barn door.) Still, the news hardly seems to justify the turnaround in Facebook sentiment. People who liked Facebook at $38 ought to be deliriously smitten at $27 – but they aren’t.

It so happens that there are good reasons for this change, reasons rooted in principles of economics, business valuation and corporate governance. Those principles apply, of course, to IPOs – except that, very often, the hype and gamesmanship surrounding initial offerings seem to temporarily sweep such considerations aside.

In some ways, the rules of investing mirror the rules of dating. You may salivate at the thought of connecting with that gorgeous, mysterious newcomer, and you might feel a rush at the first contact. But when it turns out that the new flame is pretty much like your previous partners, chances are good that the romance won’t last.

In theory, the first day a stock is traded should look a lot like the second day, or the 10th, or the 30th. A company’s prospects almost never change radically over such a short time period, especially one in which managers are subject to a “quiet period,” in which they do not announce major news. One such quiet period is the weeks following an IPO.

Therefore, if a company’s stock has been priced fairly – neither too high nor too low – at the IPO, the stock should exhibit only fairly small fluctuations over subsequent days and weeks, some of which will mirror the movements in the general stock market or in the company’s industry.

This, however, is not how IPOs usually work. Investors don’t even expect IPOs to behave in such a boring way. They expect, or at least hope, for an underpriced IPO, which will shortchange the company that is going public, but will allow investors to experience a short-term “pop” that makes them feel good. Aggressive traders seek out IPOs just to exploit this pop, with no long-term interest in owning the company in question.

Unsurprisingly, companies do not like being shortchanged when they go public, and they don’t like having their stock end up in the hands of speculators and traders, either. Very few companies manage to avoid these results as well as Facebook did, however. As the most eagerly awaited IPO in nearly a decade, and under the leadership of a founder who was never that keen on going public in the first place, Facebook was perfectly positioned to hold out for the absolute top dollar at its IPO. It got the investors who bought its shares on March 18 to pay the full value of the company – and then some.

Let’s explore “and then some.” Only about 15 percent of Facebook’s stock, or $16 billion, was sold to the public on May 18. Most of the stock remains firmly in the hands of the company’s insiders and early backers.

Suppose someone else with very deep pockets – maybe Google, or IBM, or Microsoft – decided on May 19 that Facebook would make a wonderful addition to the corporate portfolio and therefore proposed a merger. How much would they have paid?

Usually, when someone proposes to take over a public company, the offer includes a substantial premium over the recent trading price of the target’s stock. This makes sense, because the shares that routinely trade every day on the market represent just a minority interest that has no control over the company’s operations. The acquiring company is willing to pay a premium for control. Seen from the opposite direction, the daily stock market price reflects a built-in discount that applies to a minority, non-controlling interest.

Facebook’s investment bankers touted the fact that the IPO price valued the entire company at $105 billion. But if the entire company was worth $105 billion, then the buyers of IPO shares must have overpaid, because they did not receive a minority interest discount. On the other hand, if the IPO price was reasonable at $38, then a hypothetical acquirer would have had to be willing to pay a significant premium – maybe 20 or 30 percent – above that price to obtain control.

In hindsight, it seems that the $105 billion valuation included a healthy control premium, so the IPO investors probably overpaid. But we cannot know for sure, in the absence of a genuine and serious takeover offer, which is nowhere in sight.

These issues are not unique to Facebook. Sellers who hold controlling stakes in companies typically do not want to take the haircut that a minority interest discount requires in order to go public. Most sellers, however, do not have the leverage that Facebook had in order to avoid it.

Facebook may yet prove to be a profitable investment for those who bought at $38 or more, if they hold their shares long enough, and if Mark Zuckerberg and his team can continue to build a profitable business on the “likes” of 900 million people or more. The profits would be better, of course, for someone who pays $27. Or maybe the whole thing will blow up when 900 million people find another way to spend their spare time.

For more articles on financial, business, and other topics, view the Palisades Hudson newsletter, Sentinel, or subscribe to my daily opinion column, Current Commentary.

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Think4urself June 04, 2012 at 11:00 PM
The wealthy,corrupt, greedy elites are stealing from the struggling,broke middle class. The muppets are like the sleeping giant-they have awaken to fact that they are being exploited and they won't be fooled again. Hence, the sliding price of FB. Start a movement and defriend this snake-oil salesman, Zuckerberg.
Mary Beth Fairmount Avenue June 04, 2012 at 11:07 PM
i don't know about that other stuff, but Facebook has Farmville which is such a good game. Plus my aunt Teresa and I can talk on Facebook and share pictures of our vacations. I think that it's a great invention I would buy the stock if I had the money and one day I hope I will. Thank you thank you thank you, very much. MaryBeth of Fairmount avenue.
Ross Revira June 04, 2012 at 11:16 PM
Sounds like somebody bought Facebook stock at the IPO price. Last time I checked using Facebook or buying the stock was voluntary.Another case of blaming someone or something else for ones own failure.
Ross Revira June 04, 2012 at 11:42 PM
Gold, great investment last 6 months lost $200 per once, over 9 months $400 per ounce but I guess those wealthy capitalist elites forced you to buy it. I guess it takes a real man to admit his mistakes.
Think4urself June 04, 2012 at 11:51 PM
I bought gold and silver several years ago, before the inflated prices.Even when the US dollar was relatively strong. Let's just say when I retire in about twenty-five years, I should be very comfortable with the portfolio I acquired. I'm just a lucky patriot who invested well and wisely. Today, investing is akin to gambling in Las Vegas with the odds stacked against the average investor.
Bob Zahm June 04, 2012 at 11:56 PM
FB @ $38/share seemed at the point in time to be fairly priced. The fact that it has gone down since the opening merely shows that the initial price was too high - but not too high for the speculators and others who were hoping to quickly "flip" the stock for a win. Too bad for them. But the last time I checked, no one had a gun held to their head to buy FB - at IPO or now.
ILoveLizzie June 05, 2012 at 12:24 AM
Think4yourself, you are a useless idiot. Mary Beth is challenged, but she is sweet. I've known her since I was seven. You should really look in the mirror, you might see a hater.
Mary Beth Fairmount Avenue June 05, 2012 at 12:57 AM
I try and admit when i make a mistake, it makes my heart feel good. I sometimes don't know when i make a mistake,but when I do I sometimes try and admit it to my mom or my brother or a friend. I love Lizze thank you for being my friend, do I know you or did we go to camp? Farmville makes people closer to animals and is good and is Facebooks. Facebooks father, the boss, is a dentist. My friends were talking and one said that the Facebook man stole Facebook from someone else. My other friend said that, so what that is the American way America was stole from the Indians. what is indian stock worth now today? Stocks are a good thing, and also my brothers friend Raul works as a stock boy, but I'm not sure if he works for facebook stock. Thank you thank you thank you thank you,very much. Marybeth of Fairmount avenue.
Think4urself June 05, 2012 at 01:14 AM
I didn't know Mary Beth was challenged. She has my sincere apology. And you're right Lizzie, she is sweet. Having said that- It's "useful idiot" not "useless idiot". It generally means that governments and corporations are manipulating the masses without them knowing it for their gain.
AH June 05, 2012 at 02:36 AM
I find it funny people misjudged this stock! I don't feel bad for the people who lost money att all! Don't trust what the media says.
Walden Macnair June 05, 2012 at 09:51 PM
Seems to me the IPO worked exactly as it was designed. It made millions of dollars for Zuckerberg which was what it was suppose to do. This just pointed out that the stock market is gambling, just like betting the ponies, only with bigger profits and losses. If you lost money; too bad.
ThinTheYuppies June 06, 2012 at 04:23 AM
far fewer regulations at the track. sport of kings, dirtiest game in town, far, far, cleaner than Wall Street. You have to be insane to be in the market today. Unless of course you're dining with banks.

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