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