SGMT 6050 Mergers and Acquisitions

Facebook IPO

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 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

in market reaction showcase shortfalls in valuation, and it is recommended that analysts

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.

Aggressive Assumptions made by underwriters

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

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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.

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by emphasizing the premise that ads are more effective if a friend recommends it on

Facebook compares to traditional online advertising. 9 It can be observed that companies,

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

31% growth rate in advertising revenue is overly aggressive.

In addition, Morgan Stanley estimated royalty revenue would grow by 17%;

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.

9 Gustin, S. (2012). Do facebook ads work? . Time Magazine, Retrieved from

http://business.time.com/2012/08/07/do-facebook-ads-work/.
10 Buley, T. (2009). Facing up to facebook's value. Forbes, Retrieved from

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/.

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 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.

Estimated fair value of common shares is much lower than $38

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

12 Supra Note 1 at p.14.

13 Supra Note 1 at p.76.
14 Ibid at p.77.

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15%. 15 The discount rate is conservative, given the risk free rate is at 2.3%, beta for IT

services is at 1.06, and the market risk premium of 7%. 16

The assigned weight of the method is questionable. Facebook assigns a significant

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

more weight to DCFM and GPCM.

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

estimates support the conclusion that Facebook IPO price is over-priced.

Comparable Company Valuation

The last reason is based on multiples generated by comparable companies, namely

Google and Apple, it can be calculated that Facebook valuation is not close to the $96.6B

valuation. See Appendix A.

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.

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 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,

asymmetry of information, and low level of corporate governance.

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

underwriters may have ignored the importance of substitution of web-accessed Facebook

usage by the mobile app accessed usage at the time of the valuation given that this risk was

not reflected in historical revenue record.

The second challenge relates to valuation is asymmetry of information, which is

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

cannibalization of Facebook revenue by the increasing popularity of its mobile app

adequately to retail investors through the prospectus. 22 Investors with the additional

information were able to make a better-informed decision of whether to purchase

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.

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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

company to be higher than what it really is.

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.

Suggested Valuation Method

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.

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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

technology initiatives to renovate Facebooks current operations. In addition, real option

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

It is extremely hard to valuate a company properly, especially given a company, such

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

valuate companies with similar business characteristics as Facebook.

28 Ibid.
29 Ibid.

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Appendix A (Source: Bloomberg)

Ratio Facebook Apple Google Amazon Tech. Industry avg.

P/E 20.340 21.6990 21.9315 163.5975 17.39

P/B 3.7992 4.84476 2.80831 4.08379 3.46

P/S 4.2441 5.20827 5.37686 2.14718 Not found

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.

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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.

Buley, T. (2009). Facing up to facebook's value. Forbes, Retrieved from

http://www.forbes.com/2009/04/06/facebook-advertising-rates-technology-internet-
facebook.html.

Damodaran. (2012). Betas by sector. Retrieved from

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html.

Dunand, E. (2012). Morgan stanley fined $5 million over facebook ipo. Reuters, Retrieved
from http://www.cnbc.com/id/100322264.

Gustin, S. (2012). Do facebook ads work? . Time Magazine, Retrieved from

http://business.time.com/2012/08/07/do-facebook-ads-work/.

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.

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