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Faceplant: 4 lessons from the Facebook IPO

May 24, 2012

| MoneyRates.com Senior Financial Analyst, CFA

The Facebook IPO is shaping up as one of the biggest opening flops in stock market history. By the end of its third day of trading, the stock was down by more than 18 percent from its initial offering price, and regulators were investigating amid accusations that the investment bankers did not fully disclose concerns about the company's earnings.

Whether or not there was any wrongdoing, the reasons for the Facebook flop are understandable. In many ways, this is an echo of the dot-com bubble of the late 1990s, when emotion triumphed over logic for long enough to drive Internet stocks to prices that could only fall.

This time around, though, there is an added element. The low interest rates that have made the last few years miserable for people in savings accounts and other deposits have also played a hand in stirring up stock market risk.

Here are four lessons from the Facebook IPO:

  1. The business model matters. Facebook has done a tremendous job in accumulating users around the world and holding their attention. However, they have only just begun to realize the revenue potential of their audience. This is consistent with the Internet-based approach: draw people in with a non-commercial offering, and then steadily introduce revenue-producing elements. The problem is, that transition isn't always seamless, as users sometimes balk at those commercial elements. As an investment with a still-evolving business model, Facebook was bound to be somewhat risky.
  2. Valuation matters. No matter how great the company, the price you pay will determine the return you get. Facebook's initial offering price of $38 per share was about 88 times its earnings over the past 12 months. That means the company would need six-fold earnings growth just to support that price at a more normal valuation of around 14 or 15 times earnings. In other words, explosive growth wouldn't be a win -- it would be just enough to support the initial price. That's setting the bar for success awfully high.
  3. Low interest rates exacerbate risk. Stocks are commonly valued using mathematical models with interest rates as the denominator. That means today's low interest rates drive those valuation models higher, making the market generally riskier.
  4. Hype is hazardous. You didn't need to understand business models or valuation formulas to sense the hype that preceded Facebook's IPO. Buying into such hype is always going to be risky. Just look at last year's most hyped Internet IPO, which was Groupon. Its price has fallen by more than half since it went public late last year.

Getting back to the low-interest-rate issue, this environment heightens risk beyond just what it does to stock valuation models. Low interest rates have many people desperate for alternatives to savings accounts, money market accounts and CDs. The Facebook experience is a reminder that searching for extra return may well lead you into a whole new realm of risk.

Your responses to ‘Faceplant: 4┬álessons from the Facebook IPO’

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Scott Pilchard

2 June 2012 at 9:37 am

Excellent description of the Facebook mess. I recognize many of the valuation examples you've used in your article, and miss that writing in some of our client communications. Hope you're well.

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