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Facebook,

Inc.
The Initial Public Offering
Niranjan Zende

Prof. Trevor Larkan


FI 627
Bentley University

th
July 7 2015

I.

Introduction

Facebook is a social networking website that allows you to connect and share
memories with your family and friends online. Originally designed for college
students, Facebook was created in 2004 by Mark Zuckerberg while he was
enrolled at Harvard University. By 2006, anyone over the age of 13 with a
valid email address could join Facebook. Although Facebook did face
competition in its early stages from incumbents within the industry on a
national as well as international level, it kept growing rapidly.
Based on the data provided and analysis done, I would like to bring to light
some key concerns and suggest some recommendations for an Investment in
the IPO.
II.

Facebook Inc. Business Model

Facebook primarily generated revenues by advertising. Advertising


accounted for 98%, 95% and 85% of Facebooks revenues in 2009, 2010 and
2011 respectively. Since all user data is available to Facebook and is owned by
the company, Advertisers on Facebook were provided with the opportunity
of selecting target segments based on user data, expressed interests, social
connections and other demographics. The remainders of Facebooks revenues
were generated through their payments business, which was exponentially
growing since 2009; this unit generated $13 million, $106 million, $557 million
in the years 2009, 2010 and 2011 respectively.

Facebook had quite a few competitive advantages; large user base, Business
model built around data, ease and simplicity of use, mobile app for user
engagement and an aggressive stance towards an inorganic growth strategy.

III.

US IPO Market - Technology Industry

At the time of the Facebook IPO, the US economy was still recovering from
the 2007-09 economic crises and the global economy including Europe and
developing economies were in crisis or were faltering.

According to data in Exhibit 1, It can be observed that IPO fundraising (in


dollar terms) in the first quarter of 2012 witnessed a 70.2% decrease Year-onYear as compared to the first quarter of 2011. Also IPO fundraising (in # of
IPO terms) activity in the first quarter of 2012 witnessed a 46.9% decrease
Year-on-Year as compared to the first quarter of 2011.

Also, Exhibit 2, depicts the recent technology IPOs in the US markets whose
performance was being analyzed by Mr. McNeils Team, It is very evident
that the stock price of the companies in the industry had witnessed a pop on
the first day of being traded. Companies such as Groupon and LinkedIn sold
at a price above their initial price range. It was the overvalued intrinsic value
of the stock that made the prices fall gradually. As far as the IPO for Zynga
goes, even though their IPO price was within their price range, its
performance wasnt sustaining.

IV.

Purpose of the Facebook IPO

Today, Facebook is the world's largest social network, with more than 1 billion
users worldwide. The goal stated in the 2011 Facebook prospectus was that
Facebook intended to connect all the 2 billion global Internet users.
In 2011, Facebook Inc. made the decision of going public after noticing the
increasing popularity and presence of social media companies. Facebook
decided to go for the IPO as it would allow existing shareholders and
investors to participate in the public markets and also allow Facebook to make
use of the public equity markets for future fundraising. It was pre-determined
that the proceeds from the IPO would be used for working capital and general
corporate purposes.
V.

Valuation of the Share

The intrinsic value of a company is the actual value of a company or an asset


based on an underlying perception of its true value including all aspects of
the business, in terms of both tangible and intangible factors. This value may
or may not be the same as the current market value.1

In the case is given a Discounted Cash Flow (DCF) approach to evaluating the
intrinsic value of the company and the shares. Exhibit 3 shows the analysis of
the DCF keeping all the baseline assumptions in line with the analysis
performed by Prof. Aswath Damodaran. The only thing that has been taken
into account is the additional number of shares, which may be floated into the
public market post-IPO. This has led me to value the share at $32.47. This

price is below the price talk of $34 to $38 per share and may indicate the stock
to be overvalued if all the stocks held by the stakeholders may be traded in
the open market in the short to medium term.

Another method by which we may be able to determine the value of the stock
by using Exhibit 4, which is given below, the extract from the consolidated
balance sheet gives us the pro forma values for the pro forma for stock
options and pro forma for stock options+IPO. The difference between these 2
figures i.e. $11,998million and $5597million would give us $6,401million.
Therefore, Value of Issue/No. of shares issued = 6,401/180 = $35.56 per
share. This price is between the price range of the price talk of $34 to $38
which was updated by the underwriters as this estimation would value the
stock at $35.56 .

VI.

Key Concerns

There are a number of major concerns that an investor such as CXTechnology


Fund must pay attention to before being exposed to unknown risks. Few of
the concerns that are more important than others are as follows:

Shareholding structure completely in favor of Mark Zuckerburg Since


Mark Zuckerburg is entitled to 56% of the voting rights because of the
class B shares, the decision making power in the organizational is too
concentrated and a small mistake at the hands of Mr. Zuckerburg may
deteriorate a lot of firm value.

Sales revenue is forecasted to increase only marginally in the medium to


long term The DCF model proposed by Prof. Aswath of NYU stern
assumes that sales growth will increase at a decreasing rate and increasing
number of DAUs and MAUs are critical to sustain any substantial
growth.

At the time, Facebook wasnt able to advertise on platform on the mobile


devices, which was increasingly being adopted by users this would
hamper the sales revenue as the advertisers would be less inclined to use
Facebook as a medium for reaching out to users who access their accounts
using mobile devices.

User engagement This is one of the most important factors in keeping


the MAUs and DAUs high always, and only if these numbers are seen to
be increasing and promising would advertisers pay Facebook for
advertisements. A roadmap must be in place to keep user engagement at
satisfaction at an all time high.

User data security and privacy Facebook has taken a lot of heat in the
recent years and even years preceding the IPO in regard to the social
values of the social media behemoth. Underage users and Social
experiments on users are only some of the proven accusations on the
company and such incidents would only erode shareholder value.

If a potential institutional investor does not pay attention to critical issues in


the industry such as these before investing, it may lead to negative returns
and also erode significant value from their portfolio.

VII.

Recommendation

As the importance or social media rises in the day-to-day operations of


corporations, it has encouraged a lot of companies to invest in social media.
Also, the previous Tech IPOs relating to the social media sub-category did
perform very well indeed and also allowed short-term traders to make money
on the first day of trading after a spike in the price.
The Facebook IPO has potential to deliver returns given their growth
trajectory and aggressive growth model. Investors may view Facebooks
positive cash flows as a good signal in the future of the company.
CXTechnology Fund should make the investment on the first day of the IPO
in Facebook in two phases at various price points. They should do so in order
to sell part of the shares and capitalize on the initial spike in share value in
intraday trades and secure some returns and the other part in order to stay
invested in the company for the long term, as it seems to be a promising
investment from the analysis.

VIII. Exhibits
Exhibit 1
Recent Technology IPOs
Company

Ticker

IPO date

IPO price

Gross Proceeds

1st Day Total


Return

1st Week Total


Return

1st Month
Total Return

LinkedIn

LNKD

19-May-11

$45.00

$352.8 million

109.4%

91.9%

Groupon

GRPN

3-Nov-11

$20.00

$621 million

43.0%

21.3%

45.6%
-5.3%

Zynga

ZYNG

16-Dec-11

$10.00

$1 billion

-5.0%

-6.1%

-11.3%

Exhibit 2
Market Statistics on US IPOs
Quarter

Number of deals

Q1'04

339

Q2'04

385

Q3'04

339

Q4'04

457

Q1'05

327

Q2'05

409

Q3'05

364

Q4'05

452

Q1'06
Q2'06

%chg QoQ.

Quarter

Capital raised ($B)

%chg QoQ.

Q1'04

29

14%

Q2'04

33

14%

-12%

Q3'04

29

-12%

35%

Q4'04

39

34%

-28%

Q1'05

29

-26%

25%

Q2'05

39

34%

-11%

Q3'05

38

-3%

24%

Q4'05

74

95%

360

-20%

Q1'06

39

-47%

473

31%

Q2'06

66

69%

Q3'06

355

-25%

Q3'06

49

-26%

Q4'06

608

71%

Q4'06

112

129%

Q1'07

395

-35%

Q1'07

37

-67%

Q2'07

574

45%

Q2'07

95

157%

Q3'07

442

-23%

Q3'07

59

-38%

Q4'07

603

36%

Q4'07

105

78%

Q1'08

253

-58%

Q1'08

41

-61%

Q2'08

274

8%

Q2'08

39

-5%

Q3'08

164

-40%

Q3'08

13

-67%

Q4'08

78

-52%

Q4'08

2.0

-85%

Q1'09

52

-33%

Q1'09

1.4

-30%

Q2'09

82

58%

Q2'09

10

614%

Q3'09

146

78%

Q3'09

34

240%

Q4'09

297

103%

Q4'09

67

97%

Q1'10

293

-1%

Q1'10

54

-19%

Q2'10

314

7%

Q2'10

47

-13%

Q3'10

302

-4%

Q3'10

53

13%

Q4'10

484

60%

Q4'10

132

149%

Q1'11

296

-39%

Q1'11

47

-64%

Q2'11

383

29%

Q2'11

66

40%

Q3'11

291

-24%

Q3'11

29

-56%

Q4'11

255

-12%

Q4'11

29

0%

Q1'12

157

-38%

Q1'12

14

-52%

Exhibit 4
Discounted Cash Flow Analysis
DCF

2011

2012E

2013E

2014E

2015E

2016E

2017E

2018E

2019E

2020E

2021E

Termina
l

Base
year

10

year

7.6%

7.6%

7.6%

7.6%

7.6%

0.0%

Assumptions:
Revenue growth rate

40.0%

40.0%

40.0%

40.0%

40.0%

32.4%

24.8%

17.2%

9.6%

2.0%

2.0%

EBIT (Operating) margin

45.7%

44.6%

43.5%

42.5%

41.4%

40.3%

39.3%

38.2%

37.1%

36.1%

35.0%

35.0%

Tax rate

40.0%

40.0%

40.0%

40.0%

40.0%

40.0%

39.0%

38.0%

37.0%

36.0%

35.0%

35.0%

Increase in CAPEX + WC as % of
sales

67%

67%

67%

67%

67%

67%

67%

67%

67%

67%

100%

Cost of capital

11.1%

11.1%

11.1%

11.1%

11.1%

10.5%

9.8%

9.2%

8.6%

8.0%

8.0%

67%

67%

67%

67%

67%

67%

67%

67%

67%

67%

100%

Free cash flow to firm ($ millions):


Revenues

3,711

5,195

7,274

10,18
3

14,256

19,959

26,425

32,979

38,65
1

42,36
2

43,20
9

44,073

EBIT

1,695

2,318

3,167

4,325

5,903

8,051

10,377

12,599

14,35
3

15,27
9

15,12
3

15,426

EBIT(1-tax)

1,017

1,391

1,900

2,595

3,542

4,830

6,330

7,811

9,042

9,778

9,830

10,027

Increase in CAPEX + WC

995

1,392

1,949

2,729

3,821

4,333

4,391

3,800

2,486

568

864

FCFF

396

508

646

813

1,010

1,997

3,420

5,242

7,292

9,262

9,162

Terminal value

152,707

Present value:
Cumulative discount factor

0.900
4

0.8107

0.729
9

0.6572

0.5917

0.5357

0.4877

0.446
5

0.411
1

0.380
6

0.3806

PV of FCFF and TV

357

412

471

534

598

1,070

1,668

2,341

2,998

3,526

58,128

Equity

Debt

Preferre
d

Capital

Value of firm

72,101.2

- Debt

1,587.0

+ Excess Cash

2,000.0

Value of equity

72,514.2

- Cost of equity options (after tax)

3,088.5

WACC

Value of common equity

69,425.7

Market values
$81,247.8

$1,587.0

Post-IPO number of shares (millions)

2,138.1

Weights in WACC

98.08%

1.92%

0.00%

100.0%

Estimated value /share

$32.47

Cost of
Component

11.24%

2.37%

7.14%

11.07%

Price talk

$38.00

Price as % of value

117%

$$82,834.8

Exhibit 4
Extract from Consolidated Balance Sheets
Consolidated Balance Sheets:

$3,910

$3,910

Pro forma for


stock options +
IPO
$10,311

Working capital

3,655

3,980

10,381

Property and equipment, net

1,855

1,855

1,855

Total assets

6,859

7,184

13,585

Total liabilities

1,587

1,587

1,587

5,272

5,597

11,998

Cash and marketable securities

Total stockholders equity

As of March
31, 2012

Pro forma for


stock options

IX.

References
1. Intrinsic Value Definition | Investopedia. (2003, November 23).
Retrieved July 3, 2015, from
http://www.investopedia.com/terms/i/intrinsicvalue.asp
Mark, K., Compeau, D., Dunbar, C., & King, M. (2014).
Facebook, Inc: The Initial Public Offer (A). In (W12453 ed.). Ivey
Publishing.