ACCA F9: How the Facebook IPO fits into the F9 Syllabus

Unless you’ve been so busy revising for the forthcoming ACCA F9 exam, that you’ve not had time to watch the news or read a paper, you must have heard something about Facebook’s recent IPO and how some investors are now suing (the share price has fallen by almost 30% within two weeks of the IPO launch).

So which parts of the F9 syllabus can i relate to the story then?

Quite a few actually, namely:

  • Chapter 1 – Financial Management & Financial Objectives
  • Chapter 12 – Sources Of Finance
  • Chapter 17 – Business Valuations
  • Chapter 18 – The Efficient Markets Hypothesis

Chapter 1 – Financial Management & Financial Objectives

Here we talk about the 3 main decisions a company faces – Financing (see chapter 12 below), Investment & dividends. Facebook now has to make some critical decisions – how to invest the cash generated from the sale of new shares to generate a return that the investors are happy with & in future years what % of earnings to pay out in the form of a dividend & what % of earnings should be re-invested into the company to support future growth.

Chapter 12 – Sources of Finance

At the initial price of $38, the IPO raised around $16bn for Facebook. Precisely what they need this cash for is yet unclear. Some people believe it was mainly to provide earlier shareholders, including some venture capitalists, with an exit strategy. At $38 per share this provided a healthy capital gain.  Mark Zuckerberg reportedly earned over $1bn from the IPO. Even earlier shareholders who didn’t sell would have seen their paper wealth significantly increase.

Other people believe that some of the cash would be set aside to fund growth, either by buying out other companies or developing products/existing strategies.

So why did they choose an IPO?

In order to provide an exit strategy or a significant capital gain to earlier investors, debt wouldn’t have been an option, nor would a rights issue. Perhaps an IPO was preferred to a placing due to the sheer scale of the amount of finance required. An IPO granted access to a wider pool of finance, including some investors who may have been targeted in a placing, as well as anyone else who wanted to invest.

Chapter 17 – Business Valuations

Just how did Facebook arrive at the price of $38 per share?  Let’s look at the various valuation techniques, using data from the ft.com:

Balance sheet
Income statement

Assets

Their 2011 balance sheet only values equity at $2.29 ($4,899/2,138) per share, though valuing shares based on the balance sheet has a number of drawbacks including under-representation of intangibles (these are particularly significant for Facebook) & as financial accounts are merely a record of what has happened in the past, they do not provide an indication of future earnings, something that investors are particularly interested in.

Dividend Growth Model

As dividends have not been paid in the last two years the dividend growth model is not appropriate

Discounted Cashflows

There is insufficient information available to carry out a valuation here.

EPS x P/E ratio

Facebook’s 2011 EPS were $0.31. this represents an 82% increase on the prior year EPS of $0.17.

The Nasdaq composite index of technology stocks (shares) shows an average P/E ratio of 15.7 times last year’s earnings, according to FactSet, a provider of financial data. Apple trades at 13.6 times and Google 18.2 times.

Even if we applied Google’s higher end P/E ratio of this sector to Facebook’s 2011 EPS, this would provide a share price of just $5.64 per share (0.31 x 18.2).

Facebook’s 2011 EPS growth is impressive, but is this sustainable? Applying the P/E ratio method to facebook’s 2011 EPS would require a P/E ratio of over 122 to arrive at a share price of $38. This is completely off the scale – a P/E ratio of 122 suggests an unbelievably high level of confidence in the future performance of a company.

Therein lies an issue – in order to generate a satisfactory return Facebook needs to rapidly increase it’s earnings at consistently high growth rates over the next few years. They have to get around the issue that many people now access facebook via mobile devices which are difficult to target by advertising, so growing advertising revenues will prove a challenge. General Motors, one of the largest advertisers in the USA, have already announced that they will stop advertising on Facebook.

This brings us back to the Investment Decision – precisely what do they need to invest in or develop in order to generate high levels of future growth in earnings? Will it be something new they are currently developing, improving something they already have or completely diversifying into something else? If I was smart enough to know the answer to that I probably wouldn’t be sat here writing this blog!

Use the Existing Share Price

Shares in Facebook were already being traded on SecondMarket (an exchange for shares in Private Companies) around the low $30 mark for much of the time up until the announcement of the IPO. After the announcement & all the hype surrounding it, market demand for shares boosted the IPO price up to $38. There is an argument to suggest that at $38 the shares were not overpriced as they were all bought at that price. However, this is bone of contention with some of the investors who are now suing Facebook.

Chapter 18 – The Efficient Markets Hypothesis

It is generally felt that most stock markets are semi-strong form efficient whereby share prices should reflect all historical information & recently published public information. It is therefore not possible to beat the market unless you have insider information, which is illegal in most countries.

The shareholders who are suing facebook are alleging that facebook revised downwards its future revenue forecast & only adequately informed a select few investors, not all of its investors. If this were true it would have meant normal investors were over-paying for their shares & also allowed the more informed investors to sell their IPO shares whilst the price was rising & make an unfair profit. It will be very interesting to see the outcome of the class action lawsuit that has been filed.

Sources:
CBC
Reuters

Conclusion

The Facebook IPO is a very interesting & constantly evolving story which encompasses many parts of the F9 syllabus. It emphasises the importance of getting the initial IPO price right – set it too low & you raise less cash than you otherwise could have and be over-subscribed. Set it too high & you may not sell all of your shares. Even if you do manage to sell all of your shares, you may have issues providing acceptable future returns on the finance raised, suffer negative publicity, law suits &  a collapse of the share price. Keep your eyes on the news, whatever happens with Facebook over the next year is sure to be of interest.

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