Last Thursday, about 24 hours prior to the initial public offering, I posted on what I thought would happen on the opening day. I argued that this was the most pre-priced IPO in history, with transactions in the private share market providing information on what investors would be willing to pay for the stock. That was the basis for my view that those expecting a large jump on the opening day were likely to be disappointed and that this would be the Goldilocks IPO, with a 10-15% bump at open. I also felt that the stock was overvalued by about a third and that what happened on the opening day would be revealing not just for Facebook (FB), but for all social media companies. The stock did open up about 12% and faded very quickly to the offering price by the end of the day. In fact, without active support from the investment banks, it would have dropped below. In the last few days, the stock has cratered, declining to about $32 at the time of this post. Here are the lessons I am taking away from this process:
Pricing versus Valuation
Pricing is an exercise of gauging demand and supply, reading investor moods and determining what people will pay for an asset, rather than what it is worth. Valuation is about estimating what an asset is worth, given its earning potential, growth and risk. You can tell whether an investor or analyst is a “pricer” or “valuer” by looking at the tools that he or she uses. The tools of choice for most pricers are relative valuation (multiples such as PE or EV multipes), where you assess how much you will pay for an asset by looking at what others are paying for similar assets (usually other companies in the same business), and technical analysis (where you use charts and indicators to gauge shifts in demand). The tools of choice for “valuers” are either discounted cash flow (DCF) or accounting based (building off book value) models.
A great deal of what passes for valuation in corporate board rooms, investment banks and portfolio management is pricing, not valuation, and the evidence is clear, especially with Facebook. In the weeks leading up to the IPO, an army of banks, led by Morgan Stanley (MS), was working on setting an “offering” price for Facebook. While I am sure that there was an intrinsic valuation done somewhere along the way, I will also wager that it was done to preserve appearances and that it had little or nothing to do with the price that was eventually set. To set that price, my guess is that the banks used two variables: the prices at which investors were transacting in the private share market for Facebook (in the mid-40s) and the feedback that they were getting from institutional investors on how much they would be willing to pay for the stock. Much of the chatter about whether Facebook was a good buy or not was framed in terms of pricing, with the optimists arguing that it was a bargain because you were paying less per user than you were at other social media companies and the pessimists arguing that it was expensive because it was trading at a much higher multiple of earnings or revenues than Google or Apple. Any attempt at full-fledged valuation, where you confronted the uncertainty and attempted to make estimates, was viewed as an exercise in speculation and guesswork. I also think that this is why the conspiracy theories, where Morgan Stanley fed inside information about future growth to institutional investors prior to the IPO and where the poor retail investors were the last ones to know, are misplaced. I am convinced that the growth rate and the prospects of the company were never key drivers in how this stock was priced and that if there is a story here, it is one of ineptitude and arrogance, rather than malice.
Momentum is fragile and requires illusions
Momentum is a strong force in markets but it is one that we don’t understand yet and don’t believe that we ever will. It is after all not only the basis for the madness of crowds and behavioral finance, but also of that most feared phenomenon in markets, the dreaded bubble. Not only is momentum driven by market moods and perceptions, but it is fragile and based ultimately upon an illusion. After all, most momentum investors don’t view themselves as such, and choose to rationalize their behavior using “fundamental’ factors. Thus, in the midst of every bubble, investors delude themselves that it is not a bubble by looking for a good reason: that tulip bulbs would become scarcer in the future, that dot com companies would dominate every business that the operated in and that the demand for real estate would always outstrip supply.
In their ideal scenario, I am sure that the investment banks hoped that the momentum that they were detecting in the private share markets and in their conversations with institutional investors would continue into the opening day and the weeks after. So, what happened on the opening day? I believe that the momentum shifted and that the hubris of the company and the bankers in the days leading up to opening day contributed significantly to it happening. Rather than maintain the illusion that the offering price was justified by fundamentals, nebulous though they might have been, the parties involved seemed to completely abandon any illusions about value and made it a starkly momentum game. This was manifested in the hiking of the offering price to $ 38 on Thursday evening and in insiders in the company publicly bailing out at the offering price. Even the maddest of crowds, when constant confronted with proof that they are being viewed as suckers, will wake up, and to the dismay of the company and the banks, it happened an hour into the offering.
Much as I would like to believe that what has happened in the last couple of days to Facebook stock is a vindication of valuation, I am a realist. There is no fury that matches that of a disillusioned crowd and I believe that what you are seeing is momentum investors, who were promised quick riches if they bought Facebook stock, bailing out. Will they stop selling at fair value? Since they have no idea what it is, why should they? If momentum shifts in the past are any indicator, you should see the price of Facebook drop not just to its intrinsic value (you have mine, but yours may be different), but to below that value. Since the company is the poster-child for the “social media” sector, I think that you will see this momentum shift play out on other social media companies.
Would I buy Facebook, Linkedin, Groupon or any other social media company? Social media is an umbrella under which you have diverse firms, some with more clearly defined business models than others and some with stronger barriers to entry than others, and when momentum shifts, investors tend not be discriminating. In the words of that eminent philosopher, Justin Bieber, you “never say never” and some of these stocks are likely to be bargains, sooner rather than later. If you are a value investor, you should be ready.