When the whole world was going gaga about Facebook’s Initial Public Offering (IPO), there was one man who did not fall for all the hype, looked at the numbers of the company, asked some basic questions and concluded “they don’t know how they are going to make money.” Looks like, he was proved right in the end. The stock was sold at a price of $38 per share, and has fallen since then. Aswath Damodaran was the man who got it right. “In hindsight everybody will tell you that they were bearish on Facebook. Nobody will admit to buying the shares,” points out Damodaran. He is a Professor of Finance at the Stern School of Business at New York University where he teaches corporate finance and equity valuation. In some circles he is referred to as the “god of valuation”. In this interview he speaks to Vivek Kaul.
Let us start with Facebook, you have been critical about their IPO pricing?
The trouble with Facebook is figuring out, first what business they are going to be in, because they haven’t figured it out themselves. How are they going to convert a billion users into revenues and income? And second, if they even manage to do it, how much those revenues will be, what will the margins etc. They don’t know how they are going to make money. Whether they are going sell advertising to these users? Whether they are going to sell products to these users? Services to these users? I think all they know right now is that they have a lot of users.
But if they have no idea of what to do with their users, how did they make the $4billion in sales that they did last year?
They are selling. 12% of that came from selling stuff for Zynga (The maker of popular games such as “FarmVille” and “CityVille,”). The remaining 88% did come from very subtle advertising. The question is that whether they can scale that up? Because right now it is kind of invisible. You can’t see it because it is relatively small. But if they want to generate the kind of revenues they want, you are going to see it on your Facebook page. And it is going to be very very clear that they are using what they know about you to pick those ads. And I am not sure people will be comfortable with that knowing that they are seeing not just your profile but your interactions. So they can see how old you are. What political party your support? What sports you like? It is all going to go. And that’s their selling point.
So it will be some sort of invasion of privacy?
It is not some sort of invasion of privacy. It is an invasion of privacy. The question is can they do that without people getting pissed off and saying I am leaving Facebook and going elsewhere. And that I think is the big unknown. Because let’s face it, they have not just a billion users, but they know more about these users than any other company on the face of this earth. If you want a company to find 35million people who fit a specific demographic characteristic, the place to go is Facebook. They can show it to you. The only question is that if you did advertise through Facebook to those 35million is this the kind of forum were they are inclined to click on an ad.
How does it compare with Google?
In case of Google it is a much more direct business model. It’s search. You click and that’s it, everybody could see what they were doing. Facebook is a much more subtle model. On Facebook you are talking to your friends, which is a private conversation between you and your friends, but when you see these intrusive ads on the side, you realize you are not just talking to your friends, you are talking to your friends and somebody at Facebook is monitoring you at the same time. That’s a very tricky challenge. So they have made the $4billion, but at the value (the market capitalization of the Facebook stock) they have they have to make $35billion. And that’s a very different game because that would mean a lot more ads on every page directly focused in on what the users are doing.
In face very frankly I didn’t realize there are ads on my Facebook page for a long time…
It is pretty subtle right now because they don’t have that much advertising. If you think of revenue of $4billion spread out across a billion users, you are going to see a very few ads because it is still on the sides. And sometimes it doesn’t even look like an ad. Right. It’s a Facebook friend with GM. You click on it and before you know it you are looking at GM’s product offerings. So it is very subtle right now. But it can’t stay subtle for them to make the kind of revenues they have to make to justify their price now. The kind of scary thing here is that Mark Zuckerberg has said that he wants to build a social enterprise and not a business enterprise.
What does he mean by that?
What he means by that is he built Facebook so that people could talk to each other. He didn’t want ads on it. For a long time he refused to take ads on Facebook until he was told that if you can’t take ads there is no other way to make money in this. So I am not sure how willing he is to go the distance because it is going to be a fight. It’s going to be a fight against not other social media companies but against the big players. The Googles and The New York Times of the world. This is a tough game to fight and you got be willing to act like a business and I am not sure is willing to yet.
You called the business model of Facebook, a Field of Dreams. Why is that?
Yeah. You ever seen that movie? Field of Dreams.
In the movie Kevin Costner moves to the American Midwest and he is walking through this cornfield. And hears this voice and it says “if you build it he will come”. He being Shoeless Joe Jackson, a baseball player from a 100 years ago. On the faith that these old baseball players will show up, he builds this baseball field in the middle of Iowa and everybody asks him, why are you building this huge baseball field in the middle of nowhere? And he tells them, if I build it they will come. And that in a sense is what social media companies are doing right now. They are building this place where there are lots of users and they are telling people trust us if we build this, they will come. They being advertisers, product sellers, they will come. But in the Field of Dreams they did come but I am not sure in these companies that they will.
Talking about the current price of Facebook how do you see it? Yesterday is closed at around $33.(The interview was conducted on Thursday, May 24,2012) Has it fallen enough?
I think it fell enough in those two days that you are going to get a consolidation. The next run on them will tell how far they might go back. The low 30s are close enough to my intrinsic value that I wouldn’t call them massively overvalued. I think there is enough potential in the company. If it dropped to $15 then it’s pretty much a bargain. At $31-32 its pretty close to intrinsic value
The intrinsic value you calculated for Facebook was $29?
So why was the stock valued at such a high price of $38 per share when it was sold to the public?
It wasn’t valued. It was priced.
So why was it priced at such a high price?
Remember they weren’t pricing it on a blank slate. They could see transactions happening in the private share market where people were buying and selling Facebook shares. And there the prices were going at about $42-43. So they said if people are buying and selling at this price, these are real transactions.
What sort of stock market was this?
For the last two years Facebook has been on what’s called a private share market where people who owned shares of Facebook were allowed to trade.
So is it like over the counter?
Not even over the counter. They are actually beyond the counter. These are private companies that are not incorporated. So this is a completely unregulated share market. Like Goldman Sachs could sell shares. Players in this market are pretty big institutional investors they are not individual investors. Transactions here have particular merit because these are two informed investors transacting and they are coming to a price. And investment bankers saw that price and they said if they are paying $42, then we should be able to sell it at $38. And they also got onto the phone and they called institutional investors. They tried to gauge demand until Thursday evening (May 17,2012). And that’s why they set the price at 4 o’clock on Thursday because that’s how late they were pushing this off to make sure that there was enough demand.
Wasn’t this a throwback to the days of the dotcom bubble?
This is how all pricing is done in IPOs. IPOs are always priced they are never valued because essentially your job as an investment banker is to sell at that price. What was unusual here was that demand and supply that they gauged collapsed. They didn’t realize how thin the market was until one hour into the offering when they saw the price collapse. It started at $38, it went to $43, and then very quickly it kind of collapsed. My theory is when you price things you are building in market perceptions, what you think will happen etc. You are basing it in on momentum. That’s a very fragile thing. You don’t want mess with it. Even people who are buying based on pricing and momentum like to tell themselves that they are buying based on value. So they look for a good story and they don’t want to have their face rubbed at the fact that they are buying because everybody else is paying the price.
In case of Facebook it was quite the opposite…
If you look at what the investment banks and Facebook insiders did in the last week they almost rubbed the investors faces in this. They rubbed it in the sense that they kept hiking up the offering price, saying we know you are suckers. At the same time the insiders were selling the shares in the week leading up to the offering. If I had been the investment banker I would have spent the last week talking about the user base, and advertising because that would have given the momentum investors a crutch. I am purely buying it because of advertising revenues. Instead it was all about pricing. They made it very transparent that they were not valuing the company. It was all demand and supply. I have a feeling that if you point to midday on Friday (May 18,2012) and say that was the time when the momentum on social media companies, not just on Facebook, shifted. And if you look at what has happened since it is not just Facebook which has seen its price collapse. It’s Groupon. It’s LinkedIn. It’s the entire sector. And I wager that there are IPOs lined up to go to investment banks of social media companies, that are either being pulled right now or being dramatically repriced.
You have said in the past that Facebook has huge corporate governance issues. Can you elaborate on that?
It has got voting shares and non-voting shares. Zuckerberg has got the voting rights. It is also incorporated as a controlled corporation which basically means that you don’t have to follow the corporate governance rules (like the Sarbanes Oxley Act) that publically traded companies need to do. They can have insiders on the board.
Is that allowed?
If you are controlled corporation it is. And Facebook has been very open about that they are going to be a controlled corporation.
How does regulation allow for something like that?
As long as you make it public. If it is a controlled corporation investors have to make a judgement as to whether they care. In case of Facebook initially it looked like they didn’t care. Right from the beginning Facebook has been very open that they are not really going to be a publically traded company and that really they are a private business that wants the capital that public markets give them. But it is going to be Zuckerberg’s company.
So they won’t give out much information?
They might give out the information but you will have no say in what they do. So if they do an acquisition…
Did they overpay for Instagram?
They paid. I don’t know whether they overpaid. But the paid and there was no accountability. Zuckerberg basically decided to pay a billion (dollars) then he told the board that I have bought the company and I have paid a billion. This is not the way a company should be bought. A CEO shouldn’t be deciding what to pay overnight and you shouldn’t be telling the board of directors after you have bought a company that I just bought a company for a billion and I just want you to know.
This is like how mom and pop shops down the road operate…
It is a way a dictatorship operates. Facebook is a corporate dictatorship.
So who influenced Zuckerberg to do what he is doing?
Google set the framework that Facebook is using right now. The voting shares, non-voting shares. Sergey Brin and Larry Page are the models that Zuckerberg is using.
Can you elaborate on that?
Until Google came along, US companies generally did not have two classes of shares. Voting shares and nonvoting shares were for a long time banned by the New York Stock Exchange. So most companies didn’t even try. So if you look at Apple, you look at Microsoft they had only one class of shares. Google essentially did two things. They did their IPO through an auction rather than through investment banks. And secondly they decided to have voting and nonvoting shares. If institutional investors had risen at that point of time and said we are not buying these shares because we don’t have enough voting rights, then Google would have been forced to go back to drawing board and then come back. Institutional investors were okay with Google doing that. Once they opened that door every social media company you look at LinkedIn and Groupon, they follow what Google did.
So these shares are listed on NASDAQ?
Yes. NASDAQ allows for voting and nonvoting shares that is the part of the reason for listing on it. The New York Stock Exchange because it is in competition with NASDAQ has now also started relaxing, they want the money, they want the listings. So they will take Facebook even if it’s voting and nonvoting shares. So this will be a race to the bottom.
So the shares sold to the public were nonvoting shares?
They are low voting shares. The shares that Zuckerberg owns have 10 times the voting rights, which means he has 57% of voting rights with 35% of the shares. And he will always make sure that remains above 50%.
So he can go ahead and buy anything without requiring clearance from the board?
Google for instance recently issued new shares which have no voting right at all. So that is the third layer. You have ten voting rights shares. One voting rights shares. And no voting rights shares. Zuckerberg can go out and raise as much capital as he wants. If he issues no voting rights he will always have 57%. He going to lock in that voting percentage.
But how is something like this allowed in a developed market like the US?
I don’t think it should be banned. Let the investors decide for themselves. Lots of countries you have two classes of shares. Its par for the course. And you just price it in.
It’s just that it hasn’t happened in the US for a long time?
I think you will wake up one day and see I wish I had voting rights. But you chose to be a part of this game. I am not feeling sorry for the institutional investors in Google who are crying about the fact that Google does things they don’t like. You bought the stock you live with it.
(The interview was originally published in the Daily News and Analysis(DNA) on May 28,2012. http://www.dnaindia.com/money/interview_facebook-is-a-corporate-dictatorship_1694603)
(Interviewer Kaul is a writer and can be reached at vivek.kaul[email protected])