Wednesday, December 12, 2012

Understanding the fall and rise of Facebook's stock

While the rear view mirror always allows for the most confident commentary, I wanted to offer a few thoughts explaining the"whys" behind the price action in Facebook's stock. I worked on Wall Street for nearly a decade before a series of health problems moved me to resignation, so I thought I'd share my observations.

Facebook stock price, from Google Finance

Popular media aside, the extreme volatility in FB hardly reflects true swings in valuation, nor does it likely reflect investors "forcing" Zuckerberg and Company to strengthen their mobile platform. Supply and demand, as per usual, are the main stars. Valuation is but one contributor to supply and demand. (In fact, studies show that the volatility in stocks is in no way warranted by changes in real valuation). The two other keys to this story are risk-reward and an agent-model portfolio investment.

Risk-reward is market parlance for "how much upside can I expect versus the amount of downside." The more uncertainty involved, the greater the return required by the investor. From a large revenue standpoint, Facebook is still an early player. Namely, if they execute things well, they have the possibility of rapidly growing their revenues (they have largely already succeeded in rapidly growing their user base). However, the question was never "is Facebook worth $100 billion?" Rather, the question market participants ask is "what is the upside at $100 billion market capitalization?" This is a subtle but very important difference. Based on current revenues (and thus price multiples), it was hard to justify a 50% increase in valuation, however, a 50% decrease was by no means inconceivable. In essence, the risk reward wasn't there. Initiate decline.

This decline was further exacerbated by the employees coming out of "lock up." For many, this was a first opportunity to move from being "paper rich" to "cash rich." As the supply of stock waned (employees slowed their equity exits) and the demand increased (more favorable risk-reward), prices stabilized.

We can make a strong case that the recent rebound has been due solely to favorable risk-reward (you could double your money simply by returning to the IPO price), and the lack of insider selling. However, this fails to recognize a third, very powerful aspect: the agent-model of portfolio management.

In the agent-model of portfolio management, investors with cash (often large institutions) pay somebody to manage their money (for a fee). They will frequently evaluate the performance of the manager and reallocate funds to or from the manager given their performance.

The evaluation of a portfolio manager is a funny thing. Quite opposite to trading, where gains are overvalued and losses under-attributed, in portfolio management, losses are over-attributed and gains inder-appreciated. As such, there is a string pull towards the status quo. The prudent portfolio manager will want diversified bets similar to their bogey (the metric, explicit or implied, against which they are compared). Their positions should reflect the larger picture in the global economy, all the while shuffling exact investment amounts to reflect their opinions and biases.

Facebook occupies a unique role: it is, in my opinion, one of the only credible public companies in the social media space. This isn't to slight Groupon or Zynga: rather, their float and scope as too small to be carry a ton of weight with institutional investors. As such, should social media continue to be a real market, institutional investors will need to own at least a bit of it. But those bits add up. Over trillions of dollars of investment capital, even the smallest fraction of a percentage in allocation can make a difference.


  1. Long term, Facebook has a lot of potential. Short term, Facebook faces significant challenges like all social networks do that operate at scale and try and make money through advertising. Twitter for example solved some of the tremendous technical challenges they faced but they still have to deal with finding their business model, competing with advertising dollars directed on Twitter with celebrity endorsers and even the types of companies listed at BuyTwitterFollowersReviews and others. Google Plus has the same challenges as well, but are benefiting from Google tying every single service they provide that's popular (YouTube, Gmail, etc) to G+.

    Facebook's future potential has to rest on charging money for services IMO. Not charging a monthly fee for access, but communications services, entertainment services, all kinds of things that can be tied directly to a Facebook account. In the long run, if they play things right FB is radically undervalued. That's a big if though.

  2. This is outstanding, for me this article is a best source to evaluate how this rise and fall is taking part exclusively about Facebook.