At the end of the section on equity capital markets, it’ll be great to consider a practical case study.
How about one of the biggest tech IPOs of all time, Facebook?
Mark Zuckerberg founded the company, and a few of his Harvard classmates resisted takeover attempts for years.
Zuckerberg turned down a $75 million acquisition offer in 2006 and a $1 billion offer later in the same year when Yahoo! tried to buy the company. After a few rounds of investments in 2012, Zuckerberg was finally convinced that the website was ready to go public. But 1 critical question that investors wanted to understand was How does Facebook make money?
Of course, they had a vast user base of almost 900 million people at the IPO filing but the unknowns were abundant.
- Was the company going to be able to shift successfully to mobile phones?
- How will it sell ads that will be displayed on mobile phones?
- Was Facebook able to defend its leadership position against new entrants?
Of course, it was evident that Facebook’s Meta had plenty of upsides. Advertisers are attracted to the platform because of its massive reach, high user engagement and ability to target ads at specific users based on the information users provide. Knowingly or unknowingly, which is what every advertiser dreams of, Facebook’s revenues grew at a fantastic pace. The average sales growth was above 140% between 2006 and 2011, precisely what investors were looking for. Investors want to buy the shares of a company with exponential growth potential like Facebook.
But what about profitability?
With a net income of $700 million and an EBIT margin of 47%. It was apparent that the company was ideally positioned to capitalize on its growing revenues and improve its margins even further. During the roadshow, Facebook’s stock valuation increased. In early May, the firm looked for a valuation of $28 to $35 per share. But on May 14, it was decided to go with a higher target of $38 per share. Of course, a company like Facebook isn’t IPO every day and demand was high.
Some investors were even willing to buy shares at $40. Facebook’s IPO was long awaited. The firm was famous among retail investors, which was an encouraging signal. So when the day of the IPO came on May 14, Morgan Stanley, Facebook’s global coordinator for this deal, suggested a price of $38 per share, which was very close to the maximum price indicated in the book-building phase.
The company was valued at a stratospheric $104 billion (check today’s valuation), selling 4.8% of its capital for $5 billion. After the IPO, Facebook’s share price went south for a significant time by the end of May 2012. The stock had lost more than 30% at $25.50 per share. Investors who participated in the IPO were, of course, more than unhappy. Some influential finance commentators labeled the IPO as a fiasco.
Fortunately, the story didn’t end there.
A few months later, the company’s solid fundamentals and growth perspectives convinced investors that this was one of the most valuable businesses in the world. Ten years after the IPO, the company’s stock price trades at around $175 per share.
- So what’s the lesson?
- Was this a successful IPO?
It was not.
But why not?
If I had bought one share on the day of the IPO and held it for ten years, I would have made more than four times my money, which is remarkable in ten years. Investors, however, were left with a bitter taste after the IPO, something that should never have happened. Every company wants to keep its investors happy 1 primary way to do so is to apply a small discount on the day of the IPO. Instead, ownership opted to sell at the highest range possible, which ultimately hurt the stock price for a few months.
Of course, over the long run, business fundamentals are more important. But I can also assure you that plenty of institutional and retail investors bought in at $38 per share and sold at $26. This is a bad scenario in an IPO as these investors might not return for other IPOs led by the same bank.
In conclusion, valuation is tricky, but market sentiment and book-building indications are the perfect tools for bankers to suggest the right call for their clients.
