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Thursday, Dec. 25, 2014

Unfriending Facebook

Posted Thursday, May 24, 2012, at 11:35 AM

The leading financial story of the day is not the crumbling European Union, the appreciating dollar, falling golf prices, or grossly manipulated unemployment and inflation numbers.

Rather, it is the falling value of Facebook stock (NASDAQ ticker symbol FB).

Facebook just issued an Initial Public Offering (IPO) of common stock. The first shares were offered and snatched up, at $38 per share. Before the day was over, Facebook's representative had to step in to prop up the share price to keep it from falling below $38. By the second day, the price fell by 20 percent.

So what happened?

It seems that virtually every human being on Earth has a Facebook account. Facebook offers everyone the chance to expand their ego and indulge in a narcissistic high. With the ultimate product and a worldwide consumer base, how could it go wrong?

The IPO pre-release hype reached stratospheric proportions. So much so, offer price was elevated $10 more by the IPO date than the stock underwriter's original estimate.

Since a stock's value is based on profit, let's look at the Facebook business model. What do they do? How do they make money?

Effectively, Facebook provides a 21st Century hybrid between a newspaper and a narrow cast television station. That means that Facebook's revenue comes from advertising. If you want to know why so many newspapers are going out of business and why so much television is low-budget "reality" programming, it's because advertising revenues just aren't there.

The Price to Earnings ratio of the stock on day two of trading was estimated to be 88.3. That means it would take 88 years of corporate profit at today's level for the company to be able to buy back all of its stock. At the height of the "DotCom Bubble," the marked PE was 45. The historic PE average for stocks is 16. That means Facebook stock was way over priced and it took less than a day for reality to set in.

I have learn that in most things, when a decision is based on emotion, I am much more likely to have regret than decisions based on cold logic. I also learned that index funds, like the S&P 500 mutual fund, outperforms 85 to 90 percent of all managed stock funds every year.

If unmanaged index funds outperform 85 to 90 percent of the best and brightest in the financial industry, it is probably not a good idea for you and me to try to pick stocks and time the market.

So what happened? The stock was offered to the public for the highest price they thought they could get. That's reasonable. Most buyers purchased the stock based on emotion without much research into the financials of the company.

All financial markets are moved by two forces: Fear and greed. The investors (gamblers) who thought they would be the first in and ride a wave up (greed), rapidly learned the financial truth and tried to get out (fear). If you chose to gamble, always remember, if you can't see who the patsy at the table is, it's you.

If history is our guide, we can expect the stock price to continue to slide until the share price comes in line with corporate earnings with a PE ratio of about 15 to 20 percent.

These are just my thoughts on these subjects and you follow them at your own risk.

It is always a bad idea to invest in what you do not understand. People should do their own research before making investment decisions.



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