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Was The Facebook IPO Valuation Wrong

By Edited Jun 18, 2015 4 9

Social media IPOs (Initial Public Offering) have been mounting in recent years, with companies like LinkedIn and Groupon having made the news, but it wasn't until Facebook finally listed on the stock market that the hype really took off.

With over 500 million users of Facebook, it is difficult to meet people that aren't on Facebook. It is by far the largest and most used social media site, so it is understandable that there would be a lot of interest in it. The young and somewhat geeky founder Mark Zuckerberg has risen to a level of stardom and he continues to run the company with a controlling stake even post IPO. Even a Hollywood movie with the title "The Social Network" has been made about the story of Facebook and its founder.

But as of August 2012, a mere three months after the stock went public, the share price is not living up to the hype. The big question is why this is so and whether this could have been anticipated.

Was The Facebook IPO Valuation Wrong

How Does Facebook Make Money?

As Facebook doesn't charge its users any kind of membership fee, this raises the question how a company with so many customers actually makes money. The answer is simple: advertising. Many people don't even notice a lot of the advertising banners on their Facebook pages, but if you consciously look you will notice them in sidebars and increasingly in your news feed.

Online advertising can be a very lucrative business, where essentially Facebook gets paid a small amount every time someone clicks on an advertising banner or link. Over the last ten years this has become an industry with revenues in the billions of dollars, with Google being the biggest online advertising business.

So the attraction with Facebook is that it has a very large potential to earn income from its 500 million users clicking on advertising links. Of course nobody knows how big that potential really is, and more importantly nobody knows whether Facebook could end up being another Myspace that eventually loses its attraction.

 

What Has Happened To The Share Since The IPO?

Facebook (ticker: FB) was launched with an IPO price of $38 on May 8, 2012. What this means is that stock brokers were able to offer the stock to their customers at that price and trading of the stock started on May 8. If you were not able to get a deal with a broker because their allocation had already sold out, you were able to start buying the stock on the NASDAQ market.

In the first 24 hours the stock reached a peak of $45, but things quickly turned negative. Within a month the stock was trading at $26, a 32% decline from the IPO price, and by the date of this writing the stock is trading at about $19, a 50% decline.

At a $38 IPO price the company was valued at a whopping $100 billion, the largest IPO in history. This raises the question as to where such a large valuation came from and how it was justified. At the end of the day, a company is worth its assets and earnings, so a $100 billion valuation would warrant some pretty spectacular numbers.

 

What Were The Original Valuations?

For the full fiscal year 2011, Facebook reported earnings of $1 billion on revenue of $3.7 billion. Certainly not a bad achievement for a company only a couple of years old, but does this warrant the huge valuation? Essentially, at the IPO price the company was being valued at one hundred times earnings. To put that in perspective Apple, a technology company with a long track record, is currently trading at about 15 times earnings. The overall S&P 500 index carries an average price earnings ratio of also 15.

To me such a valuation simply doesn't make sense. For Facebook to get to a price earnings ratio of 15 at a valuation of $100 billion, net earnings would have to rise to $6.5 billion or in other words a six fold increase. Obviously some people involved in the IPO believed that such an achievement would be possible, as did the thousands of people that subscribed to the IPO. Question is how realistic was this?

 

Too Much Hype?

The pie in the sky valuations were quickly dealt a blow when the stock plunged within days of the IPO, as outlined above. The stock ultimately plummeted to $19 by August 2012, with the final leg down coming after a very disappointing earnings report. Essentially Facebook actually made a loss in Q2 of 2012, which is very much in the opposite direction of what is needed to justify a $100 billion valuation.

Facebook's Great IPO Bust

Who Gained? Who Lost Out?

Obviously Mark Zuckerberg was going to be the biggest winner no matter what the IPO price was going to be. There were also a few others who had smaller share holdings at the start of the company's life, and they too were going to win big as they had little of their own money invested; as students they of course did not have much of.

The next group of people that won big time were a group of wealthy people who were able to take up a private offering in 2010. These people were able to put up tens and even hundreds of million dollars and even at a share price of $19 will be big winners.

The losers are the ones that took up the IPO or bought on the open market within days of the stock going public. They are potentially sitting on a 50% loss on their investment which could take a long time to recoup. I imagine they are not too happy.

Some market commentators are pointing to the fact that securities laws and regulations surrounding IPOs are so costly that Facebook was not in a position to go public in 2010, when it chose to opt for a private offering that is far less costly. Of course, if the cost of bringing a company public were not so high, a lot more average citizens would have been able to buy into the company several years ago, at much more realistic valuations and conditions that those who took up the private offering got.

 

Note to readers: I am not advising to buy, sell or short the stock and am not a professional in the investment world. I am merely highlighting my opinion on this subject.

Image Credits: jolieodell

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Comments

Sep 16, 2012 6:27pm
accordionplayer
Thanks for the article. A good analysis of the IPO. It will be interesting to see how this all plays out in the long term.
Sep 17, 2012 1:37pm
DaddyDadChris
Thanks for leaving a comment
Sep 17, 2012 10:50am
javrsmith
The Facebook stock price has been increasing as of September 2012. The IPO valuation seemed to be too high, though.
Sep 17, 2012 1:38pm
DaddyDadChris
Time will tell if current valuations are too high as well. Thanks for the comment
Sep 18, 2012 10:18am
psidwell
As an occasional user of Facebook (formerly heavyweight Facebook champion of the world), I've always viewed its IPO as overpriced. It was based on hype, not actual performance. Well, in the business world, hype doesn't pay the bills (or investors), results do. And Facebook has yet to perform.
Sep 24, 2012 2:21am
DaddyDadChris
I agree, proven income is the only thing that should count. If you buy into a company because of what it may some day earn then you are speculating, not investing. Thanks for the comment.
Sep 20, 2012 5:37am
Pindar
Well-written and informative article. I believe that the entire stock market works through hype and emotion. It is virually impossible to predict but you can certainly influence it towards a direction; politicians do it all the time. Yet facebook is much hyper than the norm. I really wonder if they Zucky and his mates had expected such a price drop of the stock. With a 1 to 100 stock evaluation it was to be expected.
Sep 24, 2012 2:23am
DaddyDadChris
I wouldn't go as far as saying the entire stock market, but certainly a large amount of it is based on hype. Very few people actually bother to look at the fundamentals and proven track record. Thanks for the comment.
Oct 21, 2012 7:08pm
RapidDash
The valuation is still extremely expensive. With a PE ratio of 100 at current prices. It is too much. It is purely a speculative play. For a company to have that valuation it needs to double earnings per share every year which considering that most of the people that are interested in facebook already have an account is almost impossible. Then again I am more on the value investing side of investing so at current prices I would not touch them with a 10 foot pole. I would consider buying them at $5 if they ever go that low.
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