Wednesday, July 31, 2013

Market Mood Swings: Facebook Euphoria

Facebook's stock price briefly hit $38, its IPO price, just before today's opening bell. In the 15 months since it went public, the stock had certainly had its ups and downs as evidenced in this graph:

As some of you who have tracked my blog posts over the last couple of years know, I have tried to make sense of Facebook's value and how the market has been pricing it. Given today's news, I thought it would be useful to go back first to these earlier posts and then do a fresh valuation of the company, with updated information.

The lead up to the IPO
Facebook had perhaps the most elaborate run-up to an IPO in stock market history, with billions of dollars in transactions in the private share market, stories aplenty in the news media and even a hit movie about its founders. My first attempt at valuing Facebook was in February 2012, when I attached a value of $68 billion to its equity, with extremely generous assumptions on revenue growth and margins. In estimating this value, I assumed that Facebook would have a revenue growth path very similar to Google's, while sustaining operating margins like Apple. 

As the initial public offering drew nearer, I grew increasingly wary about the offering for two reasons. The first was the sense that many investors, especially institutional, seemed to think that the Facebook IPO was an absolute no-lose proposition, no matter what the offering price was, since momentum would carry the stock higher. In this post, from February 2012, I cautioned investors from buying into this proposition. The second was that the company and its bankers seemed to assume that they could set the terms for the offering and that the market could go along. In my experience, those who believe that they have power over markets realize otherwise, sooner rather than later.

On May 17, 2012, just after the lead investment banks set the offering price at $38/share and the day before the offering date, I did my final pre-IPO valuation and estimated a value per share of about $25/share. While you can get the excel spreadsheet containing the valuation in this post, I think this picture better illustrates the assumptions and linkages that went into my estimate of value:

The actual offering date is now part of market lore, from the technical problems that NASDAQ had in getting the trading started to the substantial support that the investment banks had to offer to keep the price from collapsing. After an initial spurt in the price to $42, the stock ended the day at $38.23 a share.

Once the price support faded, the stock price retreated in the weeks after the IPO to drop below $30 in June 2012. In a post after the IPO, I argued that the market reaction to the IPO was just desserts for the arrogance and hubris of both investment bankers and the company in the lead up to the IPO. 

The Early Returns
In the months after the IPO, Facebook faced a mountain of troubles, some of its own doing and some reflecting the costs of going public. The IPO failure colored investors' views of the company and its management, leading them to put the worst possible spin on every action and occurrence at the company. At the same time, the IPO also exposed the company to significant costs, especially as the costs of stock-based compensation were recognized, leading to a drop in operating income.  The nadir for the stock was the quarterly earnings report about a year ago, when the company reported sagging revenue growth and much lower margins. The momentum game turned fully against the company, with many of the analysts and institutional investors who had been cheerleaders in the pre-IPO days arguing that the stock was a "sell".

On August 20, 2012, Facebook had dropped below $20/share and I made an argument that the market had over reacted to news and that the earnings reports were not as catastrophic as they were perceived to be. I also argued that investors were being distracted by side stories about expiring lock ups and mobile mashups. In fact, my estimate of value in August 2012 was $23.94, just a couple of dollars below my estimate on the day before the IPO. At the end of the post, I noted that I had a limit buy order at $18/share on the stock and that notwithstanding my concerns about corporate governance in the company and the near term effects of momentum, it looked like a decent buy. 

Now, a confession. I had never, ever bought a stock on the date that it hit its absolute low, until my limit order for Facebook got fulfilled at the start of trading on September 4, 2012. The stock hit its low of $17.58 that day and, even with setbacks along the way, it has not looked back since. I would love to claim timing precision but it was absolute luck, and I would rather be lucky than good.

Learning from Earnings: Updating the Facebook valuation
If the first two earnings reports were viewed as negative surprises, they did bring expectations down for the company and the company has delivered positive earnings reports in its last three earnings reports. While it is easy to get lost in the minutia of these reports, here are the news stories that I see embedded across the earnings reports:
  1. Revenue growth continues to be strong: Revenues at the company over the first two quarters of the current financial year have been about 46% higher than revenues in the first two quarters of the last financial year, just above the expected growth rate of 40% used in the IPO valuation.
  2. Operating margins remain high: Operating margins declined last year, primarily because of the expensing of stock-based compensation from pre-IPO days. That load has been lifted in this fiscal year and the operating margin over the last four quarters is about 30%, if R&D is expensed, and closer to 40%, if it is capitalized.
  3. Facebook remains for the most part an "advertising" company: While Facebook has made attempts to broaden its revenue base and product mix, it remains dependent upon advertising for 84% of its revenues in the last four quarters, not significantly different from pre-IPO days.
  4. Facebook seems to have broken the "mobile media" code: It is true that the last few earnings reports have included good news on the mobile media front, with Facebook showing the capacity to deliver, but am afraid that I don't share the euphoria with which some investors have greeted this news. Don't get me wrong! Being successful in mobile media is critical to Facebook's success but the revenues that I (and others) have projected for Facebook last year assume that success. So, the good news in the mobile media market keeps them on the forecasted revenue path, but failure would have been devastating. 
  5. Management has matured: If there is good news that came out of the botched IPO, it is that the managers at Facebook (from the top down) seem to have learned two critical lessons. First, they no longer seem to be taking markets for granted and are taking the effort to explain not only what they are doing but why. Second, they seem to have realized that analysts and bankers don't lead the market, but follow it. Nevertheless, the company remains a corporate governance nightmare, with voting rights concentrated in Mark Zuckerberg's hands, but at least for the moment, he seems to be behaving more like a benevolent monarch than a malevolent dictator. 
Incorporating the information in the last earnings report, I tweaked my valuation of Facebook and the word "tweaked" is used intentionally. None of the big news in the earnings reports represents significant departures from assumptions made in earlier valuation. The good news in revenue growth and operating margins was already being assumed and the fact that Facebook remains an advertising driven company puts limits on how big revenues can get. My estimate of value per share for Facebook has risen from $24/share at the depths of despair last August to about $27.65/share today (July 31, 2013). As always, you are welcome to download the spreadsheet and replace my assumptions with yours.

So, what now?
The old "buy and hold" advice, where we are told to buy good companies and leave them in our portfolios for posterity, makes little sense with growth companies, where markets often over shoot and under shoot. Last August, it was my belief that markets were over reacting to limited information in an earnings report from a young company and pushing its price down too much. Today, I believe that the markets are over reacting again to limited news from an earnings report and pushing the price up too much. As an investor who was lucky enough to buy last August, because the stock was trading below my estimate of its intrinsic value, I have to be consistent and sell, if the opposite holds now. The only pragmatic consideration that I have relates to taxes, since I will save substantially, if I can wait until September 4 to sell (when my gains will become long term capital gains).

So, what if you don't own the stock? Should you sell short? I personally would not, since it is entirely possible that the momentum game that was so firmly against Facebook last year might work in the other direction now. There may be investors who will be drawn in to the stock if it crests the $38 IPO price, though there is really no economic or value significance around the number. 

One final note. Even though I am selling Facebook, I will continue to follow the company. After all, the company may very well fall out of favor with investors in a few months and be back on my buy list. Bipolar markets are sometimes an intrinsic value investors best friend.

My previous posts on Facebook
The IPO of the decade: My valuation of Facebook (February 16, 2012)
Facebook: Playing the IPO pop game (February 26, 2012)
Facebook and Field of Dreams: Hoodies, Hubris and Hoopla (May 17, 2012)
Facebook: Sowing the wind, reaping the whirlwind (May 23, 2012)
Facebook face plant: Time to friend the company (August 20, 2012)
Much ado about liquidity: Lockup Expirations and Stock Prices (November 19, 2012)


lamden said...

When you were willing to buy FB @ 18, why didn't you sell puts, either with a strike at 18, or a little higher to create an effective purchase price of 18. That way even if it never hits your entry price, you would collect a free premium? What am I missing?

Aswath Damodaran said...

Options on high growth stocks are an expensive game to play, because the time premiums are high (reflecting the volatility). If I had a more strongly held, short term view, I might consider them, but when I bought Facebook on September 4, I was prepared to be wrong for a long time before the market came around to my point of view. I just got lucky on timing!

Jason DaCruz said...

Thanks for the insight Professor -- but don't be too modest about timing your purchase!

I know you said to avoid getting caught up in the minutia, but I have to ask: what colors your projections for FB's revenue growth? Is it only by comp'ing to GOOG and similar tech/media/ad hybrid companies, or are there some arithmetic gymnastics regarding the existing userbase and opportunities for expansion?

I'm a bit too risk-averse to jump into stocks like this, but I'm glad to see it worked for you!

Anonymous said...

Thanks for the post. Have you decided whether to sell now or wait until after Sept 4th? Given the huge tax savings it seems hard to justify selling now as opposed to waiting 1 month.

Aswath Damodaran said...

I am holding off selling but I will buy protection with put options to lock in my profits.

Aswath Damodaran said...

I am not being modest. It was completely and totally attributable to luck. On the revenue projections, I am using Google as my prime example but keeping an eye on both the overall advertising market and the portion that is online. That is what I meant when I said that the failure of Facebook to break out of advertising constrains their value. If they can figure out a subscription model (a la Linkedin premium) or a well to sell products and services (a social media Amazon) or gaming, they could have a breakout in value.

Anonymous said...

Great post Professor! Congratulations on the trade, and of course, the FB story is far from over. I look forward to your future posts on this topic.
Maybe next time for growth stocks, you could trade in a tax-free account especially when your holding period is much shorter and the potential gain much greater.

Anonymous said...

So when are you opening your own shop? I would love to give you money to invest....

Anonymous said...

Great Post!

Pls could you do a deep dive on AAPL and hope you go on CNBC more...

Anonymous said...


Thanks for sharing your work. Congratulations on a successful investment. I'll take the other side of selling right now. I'll also take the other side of skepticism on buying and holding great growth companies.

On July 1, we purchased Facebook at $24.36. My expectation is that this will be a $180 billion company within 5 years (a double from today's price of ~ $36 per share). Growth rates are accelerating, Facebook is the most highly rated large and public company on Glassdoor, their young founder appears to be all-in for life, they are not interested in managing their short-term earnings (choosing aggressive reinvestment instead).

I'd cite two growth companies that we've bought and held for more than a decade. And we're incredibly thankful that we have. The first is Amazon, which has been called overvalued all the way (in large part because they so aggressively reinvest). The stock has risen 100X since my brother bought it. The twists and turns of the stock price didn't matter to the business owner.

The second is Starbucks. We got booed off the TV show The View for recommending it and having it fall 30% within 3 months. That was in 1998. Holding ever since has been a delight -- rising around 15X in value -- even though the stock has been halved more than twice.

The challenge for buying-and-holding great growth companies is in how true you can be to the concept. Starbucks is up 24.5% per year since its IPO in 1992. Whole Foods is up 19.0% per year since coming public in the same year.

Facebook is too large to deliver those sorts of returns over the next 20 years. But I have confidence the business will flourish as will the valuation over the next 5-10 years. It is likely to get halved at least once over that time. The beauty of the markets is that we can both be right -- although I will pay less in taxes, while adding on dips to further enhance returns.

Foolish best!

Tom Gardner

Anonymous said...

So why buy puts with expensive premiums instead of selling covered calls?

lamden said...

If he would sell covered calls, he would be on the hook for the downside.
But I still don't get, when The Professor wanted to buy FB at 18, had he SOLD puts with a strike of 18, he would have TAKEN ADVANTAGE of the high time value of the option, not suffered from it- so if you are willing to buy something for 18$ a share, and now it's trading at say 22$, it should be a bo-brainer to SELL puts with an 18$ strike, and either one of two things will happen: it will hit the strike, and you will be forced to buy @ 18, which you were willing to do anyway, or it won't , in which case you will collect the premium. What is wrong with this reasoning?

Mark Dreison said...

Great insights into Facebook stocks, professor.

Anonymous said...


Long-time listener (and admirer) of your work, first-time caller. As usual, your blog post doesn't disappoint, but I would challenge one thing you wrote:

The old "buy and hold" advice, where we are told to buy good companies and leave them in our portfolios for posterity, makes little sense with growth companies, where markets often over shoot and under shoot.

Over the years, my investing experience has taught me that "good companies" with lots of potential to grow are exactly the types of companies investors should be buying and holding. Here are 3 reasons.

1. Quality trumps quantity over the long term

Our models are inherently inaccurate. As Yogi Berra famously quipped, "It's tough to make predictions, especially about the future." And it's even tougher to create accurate models using those predictions.

That doesn't mean we shouldn't make a model. But I think it's important to understand that good companies with lots of growth potential tend to have more options for growth than we may be able to see and model. And investing in quality companies at reasonable prices over long periods of time tends to pay off handsomely.

2. The market rewards the value creators

The market's mood will almost certainly swing from euphoria to despair and back again. But the market tends to reward companies that create value over long periods of time.

Yes, it's easy to look back and see who the winners have been and how much value they have created. And yes it's hard to predict which companies will be the next great ones. But if investors find companies that show signs of being a long-term value creator (serving big markets with differentiated products and/or services, having a sustainable competitive advantage that leads to excellent ROIC, and quality management, to name a few), they should be willing to give the company time to work and grow and pay less attention to the market's swings.

3. Remeber George Costanza

One of my favorite Seinfeld episodes is when George's character decides to do the opposite of his instinct because, as Jerry says, "If everything you've had is wrong, then the opposite must be right."

A powerful force that investors must contend with is the Disposition Effect: the propensity to sell shares whose price has risen and hold on to shares whose price has fallen.

I won't say that investors should never sell stocks that have risen. That's ridiculous. But investors should recognize that the Disposition Effect costs them money over time. So in some cases, investors should consider doing the opposite of their instincts.

Thanks for listening, keep helping investors, and I look forward to you next blog entry.

David Meier

Anonymous said...

"So why buy puts with expensive premiums instead of selling covered calls"

the premiums will not be a real problem if FB rises a lot.

If FB falls, you have put options.

If FB stays flat and you are ready to sell it, you can still sell at-the-money covered calls to get back the premiums you have paid for put options.

Anonymous said...

No Luck


Apprentice of Agamas said...

"I was prepared to be wrong for a long time before the market came around to my point of view. I just got lucky on timing!"

What does an individual investor do if they want to purchase LEAPS longer than 2 years. Most stocks don't offer options farther out than 2 to 2.5 years.
Apparently Cornwall Capital (from the Big Short) managed to convince brokerage houses to get them longer term options (that what was then available).

Anonymous said...

Nice work Prof.

You have logic and data on your side. Tom Gardner (the previous commenter) has faith and belief in FB and scant facts to back it up. If it were my own money, I would put most on logic and data and a little bit on faith. If it were other people's money, or I was just pontificating at no cost, well, opinions are...

If Gardner believes so strongly in FB, I wonder if he would care to share what % of his portfolio he would put in FB.

Keep up the good work Prof. I think you are lucky in timing too, however you are blessed with common sense for not buying the IPO and now thinking that it has run up ahead of itself.

Unknown said...

Thank you Professor, I truly value your contributions.

One question: when you say you're going to purchase put options, are you planning on selling call options as well? I would recommend you consider selling a call @ $38 strike (credit of $1.85) and purchasing a put @ $37 strike (debit $1.54) for a net credit of ~$0.31 ($31/contract).

That way you're paying for your insurance by selling the upside and the max loss is $0.69 ($69/contract) with upside of $0.31/contract. Otherwise, by only purchasing the put you keep the upside but could end up paying the full premium of $1.85 ($185/contract). Alternatively, you could sell the $38 call and purchase the $38 put for a net debit of $0.28.


Anonymous said...


I don't mind being called out at all. Facebook is 3.9% of my portfolio. I wouldn't be uncomfortable with that position being larger.

I understand your concern about how little data and logic I've presented. I'll just share a snippet from an interview I carried out a few weeks ago with Chuck Royce, founder of Royce & Associates. In his primary fund, he's beaten the market by 2 percentage points per year, dating back 40 years. He is a master investor and master practicioner.

Paraphrased, he said this, "The numbers are an important part of the investing. But we find it very hard to gain a competitive advantage. The valuation models being run with a deep quantitative focus do not create substantial outlier returns after fees and taxes. The real area of opportunity is in qualitative analysis -- who are the leaders, is culture healthy and adaptive, what are the timeframes for decisionmaking, do employees return each year or is their high turnover."

My work has Facebook with a run rate of around $1.5 billion in owner earnings this year. Before buying on July 1, I spent a lot of time trying to determine if 25-30% growth rates per year for 3-5 years are plausible. I concluded that they are. Zuckerberg and team did an incredible thing by force marching their entire developer team into mobile-first work. This was a massive undertaking, which took courage to pull off in the heat of an IPO with a lot of criticism coming their way. I believe you have a founder here who does not care about winning next quarter and is not focused on the year ahead. He has the vision, the equity stake, the voting control, the youth, and the ambition to focus Facebook 5-10 years out, and beyond. In my experience, this is an absolute necessity for a great growth company that you want to buy and hold indefinitely.

John Mackey - Whole Foods. Howard Schultz - Starbucks. Jeff Bezos - Amazon. Jim Sinegal - Costco. Warren Buffett - Berkshire Hathaway. Larry Ellison - Oracle.

Someone is going to have to show me the math on when were the best times for business-focused investors to buy and sell their stocks, from year to year. The vast majority of investors would do well to find these sorts of investments, hold them, and add to them on dips.

I am rooting on some serious dips for Facebook. I hope the stock goes to $20, tomorrow morning. With an owner earnings run rate of $1.5B, 25-30% growth rates, excessive amounts of cash on the balance sheet, evidence that they have made the platform shift to mobile, and a huge market opportunity for commercialization with video. . . I believe the numbers and the narrative and the qualities of the culture and leadership support a valuation of $75+ per share within 5 years.

The beauty of the markets is we will simply see if that is right or wrong. And as I said, in the end, we can both be right. The stock may go to $24, and then rise to $75. And we all get smile over lemonade.


John Franklin said...

Great post Professor, always enjoy hearing about your latest ventures. Facebook is definitely one stock that I have been watching closely.

Anonymous said...

Hi Prof.
Do you have an "excel" for Beer company as Heineken or Bud..?

Anonymous said...

time to talk about Apple, Prof

Kylie said...

Do you think Facebook's new update will do anything to change it?

Keith Rowley said...

I often wonder how much return companies advertising on Facebook actually make on their advertising investments. Like many or most, I don't recall even one ad I've seen on that site! Of course, this is no argument for not making technically based equity investments, but again like many, I have no feel for the real value of a company like this,e especially in the long run - if there is one!

Ansgar John Brenninkmeijer said...

Do Europeans who don't have to pay capital gains tax, have an advantage over Americans who when making sell decisions have to take fiscal consequences into consideration?
Kind regards from Amsterdam.

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