Facebook and the Sad Truth About Markets

If you asked them at the time, I doubt even the fiercest Facebook (Nasdaq: FB  ) bear would have said they actually expected the stock to fall drastically after its IPO.

If the market is known for anything these days, it's irrationality, and with the hype and marketing machine cranked up to 11, it seemed pretty unlikely that Facebook's stock would plummet by half in the months after the IPO -- even if the fundamentals backed such a drastic revaluation. But plummet it has, and with the stock currently fetching 46% of its value at the start of its first day of trading, it seems like almost everyone has reason to feel burned.

But all of this turbulence is happening in the stock market. Does that make it something that Facebook investors can safely ignore when it comes to the business itself? Unfortunately, the answer is a resounding "no."

A theory of stock valuation
To be sure, in theory there should be little knock-on business concern from the crazy fall of Facebook's shares since its IPO.

In basic terms, a stock is worth what the business is worth -- or, at least, the small slice of the business that the share represents. In the open market, investors buy and sell based on how they value those shares, and with enough competing buying and selling activity -- around 39 million Facebook shares have been changing hands on a daily basis -- the market should come to a conclusion about what those shares are really worth. This is a simplistic view of the efficient markets theory, and while EMT doesn't always work, it's often plenty effective.

The process isn't all that unlike what would have happened if Facebook had brought in a valuation consultant and said, "Tell us how much our company is worth." The difference is that the stock market version is much more public and includes a lot more "consultants."

In theory, the only ways this is of significant impact to Facebook's business is if it needed to raise additional capital or was hoping to sell itself. If it had to raise capital, that capital would be pricier -- with the stock trading lower, the company would have to sell more shares to raise the same amount of money. Meanwhile, if it wanted to sell itself, the potential buyer would be able to get away with offering a much lower price than just a few months ago.

But as far as I know, Facebook doesn't need or want to do either of those things. As a result, there's a reasonable argument that says that when it comes to the day-to-day operations of Facebook -- developing new features, working on getting money out of its mobile platform, introducing services in new geographies, etc. -- none of this matters.

But that's just theory.

Investors behaving badly
What many theory- and numbers-driven views of the market miss is the fact that when it comes to stocks -- or really any other financial asset -- what you have is the cold, hard sobriety of math making a messy collision with the behavior peculiarities of the human brain.

Here's one of the risk factors that Facebook listed in its IPO prospectus:

As we continue to grow, we cannot guarantee we will continue to attract the personnel we need to maintain our competitive position. ... As we mature, the incentives to attract, retain, and motivate employees provided by our equity awards or by future arrangements, such as through cash bonuses, may not be as effective as in the past. Additionally, we have a number of current employees whose equity ownership in our company gives them a substantial amount of personal wealth. ... As a result, it may be difficult for us to continue to retain and motivate these employees, and this wealth could affect their decisions about whether or not they continue to work for us.

The two key concerns here are whether equity and other incentives will continue to work to attract the top talent in the industry and whether now-extremely wealthy current employees will continue to be motivated to do their best work.

As Foolish investors, we may look at Facebook's shares and know that after falling by 50% they're a much better deal than they were at twice this price. But do all software programmers have this same perspective? Or do they see headlines about how horrible Facebook's stock is and think that it's simply a broken stock? If they have that latter view, an offer to come work at Facebook and get stock incentives won't be a terribly attractive proposition.

And what of the group of employees that already had a big chunk of stock? Perhaps we could assume that the risk factor is mitigated because they're now only half as wealthy as they thought they were at the IPO date. But there are other problems that could now arise. With their vast riches now halved, perhaps some in this group will get disillusioned with the whole enterprise. Or they'll develop an unhealthy obsession with what the stock is doing on a day-to-day basis and spend an inordinate amount of time reading news reports and trying to divine the stock's next move. In either case, it's hardly a boon to productivity.

Rethinking the IPO?
Whether these troubles will play out in reality remains to be seen, but talent retention and acquisition is a very important issue for a high-tech, fast-moving company like Facebook, and equity incentives are an important tool for tech companies.

By getting a sky-high price for the stock on the IPO date, it appeared that the bankers did a fantastic job with the Facebook offering. The shares that the company sold in the offering were at a great price -- which is a win for the company -- and the shareholders who sold that day also made out well. But the knock-on effects of the horrible post-IPO performance of the stock will be an interesting case study in whether the highest-priced IPO is really the best IPO.

That darn Facebook stock: Buy, hold, or fold?
So the IPO was priced too high and the post-offering stock performance has been abysmal. But where does that put Facebook's stock today? In the new premium report "Should You Be Friends With Facebook?" Fool tech analyst Evan Niu digs in to lay out the opportunities and the risks. Click here to see more about Evan's report and find out about a year of updates on Facebook.

Motley Fool newsletter services have recommended buying shares of Facebook. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 29, 2012, at 3:42 PM, Darwood11 wrote:

    Another interesting question will be "Who was management really serving with this IPO."

    I suspect the early answer is "themselves" but I would suggest giving this stock a couple of years to shake out.

    Disclaimer: I don't own any FB shares.

  • Report this Comment On August 29, 2012, at 7:34 PM, TMFKopp wrote:

    @Darwood11

    Thanks for the comment!

    To be fair, it shouldn't be expected that the IPO serves those that are yet-to-be shareholders. Since it's the company and possibly inside shareholders that are selling, the process should be focused on maximizing the outcomes for those groups. Granted, the offering has to be good enough that buyers want to participate -- otherwise you're not going to get the IPO done.

    So in wondering whether the offering was focused on benefiting management, my answer would be "yes" -- management and the company itself. But as I asked above, it's interesting to think about whether simply getting the highest price is really what benefits management and the company the most.

    Although, thinking a bit more about your question, if you're referring to management benefiting themselves to the exclusion of other pre-IPO shareholders and the company, well, I guess that's possible. And on that... well, perhaps we could chalk that up to a risk of having an insider that owns a massive stake in the company.

    Matt

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