The Facebook Affect – Part 2

28 May

On Wednesday, May 23, 2012, a group of Facebook shareholders filed a lawsuit in a New York district court alleging that important information about Facebook’s financial outlook was “selectively disclosed” to big banks ahead of the IPO.  The legal action followed a Reuters report posted late Tuesday, which alleges that analysts at lead underwriter, Morgan Stanley, received privileged information about Facebook’s financials – information that would negatively impact its valuation (and its share price) – information that wasn’t shared with main street investors.

As a separate Reuters report noted a few hours later, Morgan Stanley and three other major underwriters – Goldman Sachs, JPMorgan and Bank of America – reduced their earnings outlooks for Facebook to strikingly similar levels ahead of the IPO.

In my mind, there are three issues with which we, as intelligent and informed consumers and investors, need to be concerned:

Valuation

In finance, valuation is the process of estimating what something is worth.  There are a number of methods used to determine the value of a company – comparables, earnings, discounted cash flow, net present value, ratio or multiples and replacement value – all of which fall into 3 basic categories:

1.  Asset-based approaches – Basically these business valuation methods total up all the investments in the business (think assets minus liabilities).  This is often difficult for internet businesses where “value” lies in the product or service, and not in “physical” assets. 

2.  Market value approaches – These approaches to business valuation attempt to establish the value of a business by comparing that business to similar businesses that have recently sold. (Note: think comparables (or comps) in home buying).  Obviously, this method is only going to work well if there are a sufficient number of similar businesses to compare.

3.  Earning value approaches – These business valuation methods are predicated on the idea that a business’s true value lies in its ability to produce wealth in the future.

Most likely the valuation of Facebook is based on the capacity it has to make money due to the incredible amount of targeted traffic that passes through daily – the same reason an ad space in Times Square is worth so much money.  Most social networking sites generate revenue from selling advertising to companies.  Facebook’s unique approach is to have members “like” a particular product, which is then advertised to friends of that member.  Facebook generates 90% of its revenue from advertising.  The remaining 10% of revenue comes from developers on Facebook Platform – a set of tools that enable third-party developers to create applications inside the Facebook environment.  So a valuation would be based on projected earnings from these two sources – in essence it is not based off revenues, but rather the capacity for revenues.  According to pre-IPO reports, Facebook had a $2B revenue figure for 2010 showing a profit for the year of $400 million.  The $38 per share IPO price valued Facebook at $104B.  With shares down 16% at $31.91, some analysts expect the stock could eventually dip to around $24 or $25 a share while some on-line bloggers place its stock value closer to $10 per share.

Exit Strategies

The big question to ask is “Why did Facebook decide to go public at this point in time?” 

Most businesses go public when they want to obtain some additional resources to finance their activities and projects.  With its $1B purchase of Instagram in April, Facebook doesn’t appear to lack capital backing for new projects.

More importantly, Facebook had little choice but to go public due to the Securities and Exchange Commission (SEC). Under the SEC’s rules, a company with more than 500 shareholders must adhere to the same financial record requirements as public companies.  Granted, they could have consolidated shareholders by allowing buyouts – and that drives what I believe is the real reason Facebook went public.

An exit strategy is a means of leaving one’s current situation, either after a predetermined objective has been achieved or as a strategy to mitigate failure.  Early Facebook investors are expected to earn more than 50 times their original investment even with the stock decline – in other words, they are sitting on millions, and in the case of a couple firms, several billion dollars in unrealized gains.  Now I have no issue with making a profit on an investment – profits drive growth and innovation.  What I take issue with is financial chicanery that reaps high payouts for some while and passing the losses onto shareholders, or worse, to the general public in the form of bailouts.

Regulation

The three financial “events” listed in my last blog entry have renewed calls for more regulation of the banking and finance industries.  I refer to them as “events” because even a casual review of banking and finance history shows that they occur too often to be labeled as “scandals” or “debacles.”  Robert J. Samuelson’s Financial Reform’s Big Unknowns, published in April 2010, does an excellent job of examining the regulation debate. http://www.thedailybeast.com/newsweek/2010/04/25/financial-reform-s-big-unknowns.html

This subject requires further examination, but I will reserve that for another entry.  I continue to believe that an informed public is better than any government regulation – and I hope this blog plays a part in that education.     

 

 

 

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