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Facebook IPO
1
Facebook, a social networking site, has grown at an exponential rate that far
surpasses market expectation, so much so that its growth rate is referred to as the
Facebook phenomenal. In 2004, Facebook had 1million monthly active users, and in
comparison, it had reached 845million monthly active users in 2011. 1 This phenomenal led
to one of the biggest initial public offerings (IPO) the market had seen in recent years, with
total capital raised to be valued at $16B, given the $38 per share offering price. 2 Facebook
was valued at around $96.6B in total. Prior to the IPO, the market perceived the valuation
with positive approval signaled by both Facebooks private market share auctions and
analysts reviews. However, as it will be examined below, Facebook has been significantly
over-valued by the underwriters. In addition, the market changed its opinion of Facebook
shortly after the IPO, criticizing the valuation of the company was too high. The differences
and Facebook should have used real option to valuate its market value.
Over-valuation
There are three main reasons why Facebook is overvalued at $38 per share.
The first reason is the $38 per share price is based on overly aggressive
assumptions made on Facebooks future revenue. Facebook generates its revenue in two
ways - display advertisements on its website and retain royalties from third-party
developers for using Facebooks online payment platform. Out of the two streams of
revenue, advertisement accounts for about 82% of the total revenue, and royalty payment
1 Facebook. (2012). Registration statement - facebook inc.. (p. 47). Retrieved from
http://sec.gov/Archives/edgar/data/1326801/000119312512034517/d287954ds1.htm.
2 Ibid. p.1
2
only accounts for 18%. 3 Lead underwriter Morgan Stanley, has justified its pricing based
on the assumptions that Facebooks revenue will grow moderately considering the
increasing popularity of its mobile app.4 Morgan Stanley estimated Facebook revenue to
grow at 28% CAGR from 2013 2016, with advertising revenue growing at 31% and
payment revenue growing at 17% per year.5 However, it is arguable that these
assumptions are overly aggressive, and they will be extremely hard to realize.
Upon examining the future prospect of revenue generated from advertising, it can
be said that the estimated 31% growth rate cannot be achieved. First of all, given the online
advertising market size, and current Facebook market share, Facebook will not be able to
achieve the projected annual growth. In 2011, Facebooks share of the online advertising
market is 27% of the $25B industry.6 It is projected that the online advertising sector will
grow to $45B in 2015,7 and given Facebooks current market share, Facebook should be
able to generate $12.15B in advertising revenue in 2015. However, this only accounts for
20% CAGR.
Second, it is uncertain whether Facebook will be able to continue maintain its 27%
market share. Facebook disclosed to the public that its current advertisers do not have
long-term advertising commitment with Facebook, and many of its advertisers only spend
a small proportion of their marketing budget with Facebook.8 In addition, many companies
have started to question the effectiveness Facebook ads. Facebook differentiates its service
3 Ibid. p.13
4 Olanoff, D. (2012, 12 17). Morgan stanley fined $5m over facebook research and handling of ipo by
massachusetts. Retrieved from http://techcrunch.com/2012/12/17/morgan-stanley-fined-5m-over-facebook-research-
by-massachusetts/.
5 Ibid.
6Raice, S. (2012). Is facebook worth $100 billion? . Wall Street Journal , Retrieved from
http://online.wsj.com/article/SB10001424052702304584404576442950773361780.html.
7 Ibid.
8 Supra Note 1 at p.13.
3
by emphasizing the premise that ads are more effective if a friend recommends it on
such as GM, are starting to doubt the effectiveness of the so-called social advertising by
pulling out their ads on Facebook. This can significantly impact Facebooks share of online
marketing in the future. In addition, Facebook disclosed to the public that it might not be
able to retain advertisers if it does not reduce its current ad price. However, considering
that Facebook is already pricing its ads lower compares to other websites - Facebook
charges $0.58 per click vis--vis the industry norm of $1,10 it is hard to argue that Facebook
will maintain its current revenue level even if it retains 27% of market share as it continues
to reduce its ad price. Given the factors mentioned, it can be concluded that the estimated
however, by looking at the current royalty revenue, it is unlikely that Facebook will achieve
the predicated growth rate. Facebook collects royalty payments from developers that use
its payment infrastructure to charge players. Currently, Zynga accounts for a substantial
portion of the royalty. Considering the intensified competition that Zynga is facing, and its
lack of ability to monetize mobile apps,11 Zynga will continue to experience sagging growth
and will not be able to contribute a substantial amount of royalty to Facebook in the
foreseeable future. Thus, it is unlikely that Facebook will achieve 17% growth in its royalty
revenue.
http://www.forbes.com/2009/04/06/facebook-advertising-rates-technology-internet-facebook.html.
11 Martin, S. (2012). Zynga shares slide nearly 5%. USA Today, Retrieved from
http://www.usatoday.com/story/tech/2012/12/17/zynga-apple-app-store-ios-iphone/1775403/.
4
Lastly, Morgan Stanley made these aggressive assumptions based on the premise
that Facebook will be able to monetize its mobile app. However, Facebook has not been
able to monetize its mobile app to-date. 12 In addition, with the growing number of users
using the mobile app as a substitute for accessing Facebook, Facebook is starting to see a
decrease in its revenue, which led to the decrease in its stock prices after the IPO. Overall,
the assumptions made by underwriters to justify the $38 per share IPO price are overly
aggressive.
Facebook has estimated its Class B common stock to be at $30.89 per share as of Jan
31, 2012, and even if one continues with the aggressive estimation method that Facebook
used, one will not reach the $38 per share valuation. Facebook adopted a mix of Discounted
Cash Flow Method ( DCFM), Guideline Public Company Method (GPCM), and Market
Transaction Method (MTM) to determine its business enterprise value and fair value of
its private share price prior to the IPO. To achieve the price of $30.89, Facebook assigns a
50% weight to the MTM, where it considers the volume of transaction of its private shares,
the timing of these transactions, the pricing of private shares in the secondary market, and
whether the investors involved in the transaction have access to Facebooks financial
information. 13 It then assigns 25% weight to GPCM and DCFM each to determine fair
value.14 GPCM uses multiples of financial ratios in comparable companies in the same
industry, and DCFM sums up the net present value of future cash flow at a discount rate of
5
15%. 15 The discount rate is conservative, given the risk free rate is at 2.3%, beta for IT
weight to MTM due to the large volume of third-party private stock sales.17 But considering
that the volume transaction and pricing of the private shares were driven by the hype of
the Facebook IPO and the positive reactions from the market prior to the IPO, it is hard to
justify that the MTM valuation represents the true value of Facebook instead of an inflated
hyped-up value. It is arguable that Facebook should have assigned less weight to MTM, and
In addition, it is hard to justify the $7.11 increase of fair market value in a span of 4
months considering that Facebook share only increased by $5.35 in estimated fair market
value between 2011 and 2012. 18 The methods discussed above and the historical
Google and Apple, it can be calculated that Facebook valuation is not close to the $96.6B
Market Reactions
15Ibid.
16Damodaran. (2012). Betas by sector. Retrieved from
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html; US Treasury. (2012). Daily
treasury long term rate data. Retrieved from http://www.treasury.gov/resource-center/data-chart-
center/interest-rates/Pages/TextView.aspx?data=longtermrate. Re = 2.3%+1.06(7%) = 9.72% Facebook
does not have any long term debt.
17 Supra Note 1 at p.78.
18 Ibid at p.77 and 78. The estimated fair value of Facebooks shares $25.54 on Mar 31, 2011, and $30.89 on
Jan 31, 2012.
6
The market has perceived the IPO with positive remarks. One analyst even valued
Facebook to be at $234B compares to the $96.6B IPO valuation. 19 Most analysts either
thought Facebook was valued right on the spot or thought it was undervalued. The hype
about the stock was more obvious in the private market. Prior to its IPO, Facebook stocks
were trading at a high of $42 compares to its $30 estimated fair market value. 20 In
contrast, immediately after the fall, most analysts jumped on the bandwagon of claiming
the underwriters have overvalued the company. Some investors even blamed Mark
Zuckerberg for failing to signal to the investors that the company has been overvalued.
The difference in market reaction showcased three shortfalls in valuation. They are
objective valuation method that fails to account for dynamic business environment,
First, the valuation method that most analysts used to valuate Facebook is based on
some types of discounted cash flow method. Analysts will look at future growth
prospective of the company, and discount the estimated profit by a discount rate that
would be appropriate to capture risks that are foreseeable given the historical financial
record. In addition, the traditional discounted cash flow method depends on obtaining
information that would allow one to correctly forecast future earnings and free cash flow,
and to assess the strength of company management and future earning abilities. The model
ignores that companies could change their business practices to the dynamic business
environment that cannot be properly valuated based on historical data. 21 Facebook does
19
Supra Note 6.
20
Smith, R. (2012). Hot item: Pre-ipo facebook shares. Wall Street Journal , Retrieved from
http://online.wsj.com/article/SB10001424052970203833004577249512827646658.html.
21
Joiner, S. (Interviewee), & Ruggeri, C. (Interviewee) (n.d.). Valuation issues in a down market Mergers and
Acquisitions series : Part 1. [Audio podcast]. Retrieved from http://www.deloitte.com/view/en_LB/lb/centers/cfo-
center/3e9619288f709210VgnVCM200000bb42f00aRCRD.htm?theme=cfo.
7
not provide adequate information to allow analysts to generate reliable valuations. It has
limited record of its profits, its revenue has been highly volatile, and the business
environment it operates in changes frequently. One instance that the underwriters may
have overlooked is Facebooks ability to monetize its mobile app as mentioned above. The
usage by the mobile app accessed usage at the time of the valuation given that this risk was
arguable that it had drove up investor expectation that a free lunch scenario will take
place. Morgan Stanley was sued and fined for only disclosing softer revenue and profit
forecasts to selective investors prior to the IPO and for failing to disclose the
adequately to retail investors through the prospectus. 22 Investors with the additional
Facebook share or not. The asymmetry of information also led to market hype. Investors,
without the softer revenue and profit forecasts, interpreted the market price to be much
higher than the private trade price prior to the IPO and the IPO price. This drove the
private share price to $42 from $34 on the secondary market. 23 Investors thought by
buying shares before IPO, they would be able to rip a bigger profit considering that the
market price will be higher than $38. 24 Lastly, the asymmetry of information led investors
to believe that it will be extremely hard to buy Facebook stocks at IPO price given the
22
Berthelsen, C. (2012). Massachusetts hits morgan stanley on facebook ipo. Wall Street Journal , Retrieved from
http://online.wsj.com/article/SB10001424127887324407504578185580869680410.html.
23
Supra Note 20.
24
Ibid.
8
mentality that the demand for the shares will not meet the supply despite the fact that of
Class B shares are locked in to be sold at a later time.25 The market hype, combined with
the surging demand of shares and the lack of investor rationality drove the valuation of the
The last challenge is the lack of corporate governance. As investors have pointed
out, the CEO of the company and the underwriters should have disclosed the information
adequately in the prospectus. The lack of corporate governance could be driven by the lack
of serious fine for improper disclosure of information. Morgan Stanley was only fined $5M
compares to the $68M underwriting fee it gained from the deal. 26 Also, the lack of
governance was driven by hubris and greed. The underwriters stand to gain a bigger
underwriting fee for a higher IPO price, and the company stands to gain more capital for
higher IPO price. In addition, it is also easier for the underwriter to justify its valuation for a
company that cannot be properly valuated based on the traditional discounted cash flow
method. The combinations of driver lead to lack of corporate governance in this case.
It is suggested that analysts and Facebook should have used real options to valuate
the company given the volatility of the business environment Facebook is in, and the ever-
changing business practices to meet these volatilities. Real option valuation allows the
company to include R&D, brand development, and technology initiatives to be built into its
valuation. 27It is also flexible enough to account for companys ability to change its business
25 Ibid.
26 Dunand, E. (2012). Morgan stanley fined $5 million over facebook ipo. Reuters, Retrieved from
http://www.cnbc.com/id/100322264.
27 Latimore, D. (2002). Calculating value during uncertainty: Getting real with "real options". Retrieved from
http://www-935.ibm.com/services/hk/igs/pdf/g510-3248-calculating-value.pdf.
9
practices in the future. Valuation will change in accordance to the options that management
will take to delay, expand, contract, switch uses, outsource or abandon projects. 28 Real
options would allow Facebook to valuate its new platforms, new mobile apps, and new
does capture the benefits of discounted cash flow model by assigning weights to future
cash flow given the past company performance in the market. 29 Given the current
Facebook operation model, it is commended that real options should be used to valuate the
company.
Conclusion
as Facebook, which does not have a long history of stable income nor information that
would solidify its future earnings. Market reaction prior to and after the Facebook IPO
indicates issues within the current valuation models that companies and analysts are using.
It is recommended that companies should start to consider using the real option method to
28 Ibid.
29 Ibid.
10
Appendix A (Source: Bloomberg)
Based on these estimated ratios, it is estimated that Facebook has the following implied values:
Valuation based on: Implied Market Value of Facebook
P/E 20.340
P/B 18.612
P/S 15.750
All figures in billions.
11
Bibliography
Primary source:
Facebook. (2012). Registration statement - facebook inc.. (p. 47). Retrieved from
http://sec.gov/Archives/edgar/data/1326801/000119312512034517/d287954ds1.htm.
Secondary source:
Berthelsen, C. (2012). Massachusetts hits morgan stanley on facebook ipo. Wall Street
Journal , Retrieved from
http://online.wsj.com/article/SB10001424127887324407504578185580869680410.htm
l.
Dunand, E. (2012). Morgan stanley fined $5 million over facebook ipo. Reuters, Retrieved
from http://www.cnbc.com/id/100322264.
Latimore, D. (2002). Calculating value during uncertainty: Getting real with "real options".
Retrieved from http://www-935.ibm.com/services/hk/igs/pdf/g510-3248-calculating-
value.pdf.
Martin, S. (2012). Zynga shares slide nearly 5%. USA Today, Retrieved from
http://www.usatoday.com/story/tech/2012/12/17/zynga-apple-app-store-ios-
iphone/1775403/.
Olanoff, D. (2012, 12 17). Morgan stanley fined $5m over facebook research and handling of
ipo by massachusetts. Retrieved from http://techcrunch.com/2012/12/17/morgan-
stanley-fined-5m-over-facebook-research-by-massachusetts/.
12
Raice, S. (2012). Is facebook worth $100 billion? . Wall Street Journal , Retrieved from
http://online.wsj.com/article/SB10001424052702304584404576442950773361780.htm
l.
Smith, R. (2012). Hot item: Pre-ipo facebook shares. Wall Street Journal , Retrieved from
http://online.wsj.com/article/SB10001424052970203833004577249512827646658.htm
l.
US Treasury. (2012). Daily treasury long term rate data. Retrieved from
http://www.treasury.gov/resource-center/data-chart-center/interest-
rates/Pages/TextView.aspx?data=longtermrate.
13