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Facebook Stock Is Underperforming In Imaginary Markets

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You know who definitely has a computer science degree? Mark Zuckerberg. I'm pretty sure about this.* But probably not accounting? So don't ask him to explain how Facebook lost 25% of its market cap in the last month:

Facebook Inc. set the price range for its initial public offering at $28 to $35 a share, in a landmark deal that would raise as much as $13.6 billion for the social network and insiders. The planned price range is on the low side of what some investors had expected. On the private-company exchange SharesPost, Facebook shares last cleared at more than $44.

I suppose there are three possibilities, which are:
(1) Something actually changed - maybe Instagram, more likely seasonally decreasing revenues - in the last month;
(2) That $44.10 value in March was too high; and/or
(3) The $28 to $35 that Facebook is filing is a little low.

Probably all three? Anyway here is my math; your math may vary depending on how you interpret the cap table and appended whatnots:

An entertaining valuation calculator lives here. This guy remains optimistic:

If Facebook ends up going public at the lower end of its price range, that would be a big hit for investors like Kevin Landis of San Jose, Calif., tech fund Firsthand Capital. Mr. Landis bought shares of Facebook on the secondary market for $31 to $32 a share over the last year and agreed not to sell the shares for six months after the IPO. "I've been surprised before, but I'll be surprised again if it ends up pricing at that low end of that range," said Mr. Landis. He adds he isn't worried yet. That's in part because the low range may be a tactic to build excitement for the IPO.

Oh, tactics. Oh, capital markets. Offer a deal that looks cheap, build an oversubscribed book of demand within the range, and then push buyers up to get a higher price and earn your 1.1% fees. For IPOs "looks cheap" tends to mean "on some sort of valuation metric," but for offerings by already public companies you can approximate it to "has a range that is below the last sale"; normally you don't quite start at a 33% discount to last sale, but then normally your last sale isn't a month ago. Also normally your last sale isn't in a private market whose predictive power is shall we say untested. Still, the argument can be made: if you liked Facebook at $44.10 in March, you'll love it at $28-to-$35 in May. Or you won't, whatever.

Speaking of IPO tactics I enjoyed this:

Shares in Carlyle Group edged higher on its first day of public trading on Thursday, after it lowered its initial offer price in response to weak investor appetite for private equity firms. By midday in New York on Thursday, the shares were 0.7 per cent higher at $22.16. The group said on Wednesday that it expected to begin trading on Nasdaq at $22 a share, below the original price range of $23 to $25 per common unit. ... While the offering was oversubscribed at the initial price range, the decision to pitch it lower was made to secure a stable base of large institutional investors, according to a person close to the situation. A lower price would also help support better trading after Carlyle’s market debut.

If you work in banking long enough you will eventually hear things like this said on extremely awkward conference calls. "Well, Dave, the book is 1.2x covered at the bottom of the range. But we think it will trade better if you move to $22. You like a stable base of large institutional investors, right? You want the deal to trade well, right?" Dave, if he is new to this capital markets business, might say something like "I do not give a shit how it trades or who holds it, I want my money," which puts you in a bit of a bind. In fact, capital markets bankers earn their paychecks in large part by preparing Dave for a below-range pricing and making sure that he doesn't say "just price it wherever the book is covered and let it trade like shit." That would be bad for the investing clients, and if you're a bank, you love your investing clients and your issuing clients with equally fervent loves.

Anyway this particular Dave is not new to capital markets, running as he does a private equity firm, so I imagine it was easier - Carlyle and its founders will be back, for themselves and their portfolio companies, and so have good repeat-player incentives to be nice to the capital markets. Lacking fiduciary duties to his shareholders may also have helped them get over the below-range pricing.

But Facebook is run by twentysomethings who are mostly new to the capital markets, by which I mean that it is run by a twentysomething who is new to the capital markets and also has tons of his own money on the table. And who is raising billions for his company and his investors. And who is, like, iconic and stuff. (There's a movie!) So you can appreciate the work that his bankers have done in talking down valuation from the $44 last pseudo-sale in March and the $40ish numbers that were apparently floating around during the Instagram deal. ("Hmm, yes, that seasonal revenue decline, that's going to be a problem" etc.) It's going to be a lot easier to push Facebook to price an oversubscribed deal at $36 rather than a just-covered deal at $38** if they launch at $28-$35 than if they launch at $38-$44.

Is that the best strategy for getting Facebook the highest possible price? Sure, whatever, I don't care. It's possible that a slightly higher starting range would still build plenty of excitement for the deal (have I mentioned: it's the Facebook IPO?), and offer a bit more room to push the price up at the high end. (Or, again: not!)

But consider for a minute the position of the underwriters. Sure they are getting paid tons of money for this IPO, but they're also only seeing an additional $2 million for every dollar they can raise the price.*** On the other hand, putting out $10bn of stock in an iconic IPO to happy investing clients will make you a lot of friends (read: trading revenue), while putting out $10bn of stock in an infamous dog of an IPO to angry investing clients will make you a lot of enemies (read: not trading revenue). And, when you're pitching your next deal, saying that you priced Facebook "above the range" is better than pricing it "at the bottom of the range," for any value of "the range." $36 on $28-$35 looks better to the CEO of than $38 on $38-$44.

In other words, a dollar of price for the underwriters here is worth, very approximately, nothing. The deal "going well" in the perception of investors and future banking clients is worth, approximately, tons. Could that possibly go some way toward explaining why the IPO will launch at a $72-$90bn pre-money valuation with, as they say, room to grow?

Amendment No. 5 to Registration Statement [EDGAR]
Facebook Sets $28-$35 IPO Range [WSJ]

* Spare a thought for the lawyer who wrote "Mr. Zuckerberg attended Harvard University where he studied computer science." "Yeah, well, I attended Harvard and actually graduated," thinks the lawyer. "And got a law degree!"

** Numbers imaginary! Not investment advice! No position in any stock named! Go away!

*** Split 33 ways.