FINS 5512

Case Analysis
Week 5
Varun Abbineni
z5093991
Facebook, Inc.: The Initial Public Offering
Founded in 2004 by Mark Zuckerberg, Facebook was designed to
help connect friends over the internet. Given its meteoric rise to the
top over the previous eight years, the Facebook board are poised to
take the company public.
The primary drivers of Facebook's revenue are social context and
its payments business. Social context refers to Facebook's
business of mapping user data and preferences, and using this
information for targeted advertising. Although the percentage of
Facebook's revenue from advertising has been steadily declining
over the past three years, advertising still accounted for 85% of
Facebook's revenue in 2011, with the balance stemming from
Facebook's payments business. The payments business has been
experiencing a dramatic rise over the past three years, with
Facebook's payments business growing ~4185% from 2009 to 2011.
As implied by Facebook's social context feature, Facebook's
primary value driver is its user base. In particular, Facebook pays
close attention to its MAUs (monthly average users), which it uses to
measure its ARPUs (Average revenue per user). In addition,
Facebook also uses DAUs (Daily average users) to map its user
engagement. This can be tied in to Facebook's advertising revenues,
as the revenues are driven largely by user volume.
Facebook has recently overtaken MySpace as the most popular
social network both within the US and globally. However, it is facing
stiff competition from Google in the broad internet space, as well as
several large social networks in particular globally, such as Linkedin,
Twitter, Sina Weibo, Orkut and Cyworld. In particular, Facebook's
2011 revenues of USD 3.7 billion (with ~USD 3.15 billion
attributable to advertising) pales in comparison to rival Google's
USD 38 billion advertising revenues over the same period. This
means that Google has the cash necessary to improve its Google+
offering and try to overtake Facebook in the social networking
space. In order to counter this, Facebook needs to raise funds to
improve its own offering and protect its position as the market
leader, and further compete against its global rivals. Given the
improving market conditions post the Global Financial Crisis and the
recent market appetite for Tech IPOs, it does appear to be a good
time for Facebook to go public and expect a favourable valuation.

One of the ways in which Facebook could use the funds raised from
the IPO is to expand internally it could hire new employees, build
its own additional service offerings and link them to the existing
offering. Another, very likely use for the money is to engage in
acquisitions. Facebook has already shown an appetite for M&A by
recently purchasing Instagram for over USD 1 billion cash and
additional stock consideration. It appears likely that this will be
Facebook's preferred use of cash, despite the relatively high
expenses involved. This is because Facebook will not have to build a
service offering from scratch, and will be able to focus on
integrating the purchased services with its existing offerings straight
away. This seems especially important in the Tech industry, where
innovation is important. Facebook will probably use a mixture of the
two aforementioned uses of cash, with most of it used for M&A.
The US equities market is improving since the Global Financial Crisis,
with a growth forecast of 2.2% in 2012, increasing from 1.7% the
previous year. While this is well short of the 3.3% average growth
rate experienced by the market during the 1980s and 1990s, it is
reflective of the fact that the market is improving slowly and
steadily from the GFC, and that this has to be taken into account
when comparing the expected growth. The emerging equities
markets appear to be faltering, however, and the European markets
are experiencing a double-dip recession. The most important
factor here, however, is the performance of the US equities market,
which is relatively better. The substantial growth in the S&P 500
index and NASDAQ 100 index since late 2011 is a positive for the
market, and could result in improved investor appetite.
Given that Facebook is a Tech company, I would prefer the
Discounted Cash Flow method of valuation in order to avoid an
unrealistic valuation and potential investor disgruntlement if the IPO
fails spectacularly. However, this method may not necessarily be the
most effective as growth rates in the Tech space are hard to gauge,
and the share price post-IPO could actually soar dramatically,
meaning that the company could have raised significantly higher
amounts of capital. A bolder valuer might choose the valuation
multiples method, focusing in particular on the Price/Earnings
multiple, as Amazon and Linkedin have exceptionally large P/E
multiples. In particular, as Linkedin is a rival of Facebook, this might
provide incentive for Facebook to be valued at a very high level.
Despite the initially lucrative gains from using this valuation
method, stock underperformance would lead to less successful
follow-on public offerings.
One factor that has to be taken into account when computing a
potential stock price is the amount of control possessed by Class B
shares, which are not being listed. The voting rights associated with

Class B shares means that the Class A shares are useful for passive
investors and speculators, who are only interested in gains from the
stock, but render shareholder activism pointless, as their votes
count for very little. It is interesting to note that despite not being
approved by NASDAQ for listing, there is nothing to suggest that
Class B shares cannot be traded privately by institutional investors
and High Net Worth Individuals looking to purchase a controlling
stake in the company, although this would only be possible if Mark
Zuckerberg himself was willing to sell part or all of his stake to the
investors in question.
Given that two of the three recent Tech IPOs experienced negative
share price movement in the aftermath of the IPO, I would be
reasonably conservative in pricing the stock. Assuming Prof.
Damodaran's assumptions hold true, I would price the stock at
around $35.50, without leaving a lot money on the table. Note
that the share price is highly sensitive to the assumptions, as a 5%
reduction in the growth rate , for instance, causes the expected
share price to fall to USD 27.73 per share.