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Archive for the ‘Finance’ Category

In early February, when Facebook’s IPO seemed imminent, Anup Srivastava, an assistant professor of accounting information and management, put together an interactive valuation tool that let people explore how tweaking different projections would affect the stock’s valuation. Built into that were Srivastava’s own projections. Projections that, as the stock’s price has sunk ever lower, have largely been proven true.

“We predicted a best case valuation of $25 billion,” Srivastava said. “The firm raised $16 billion dollars, and retained $7 billion. Facebook’s post-money valuation stands at $41 billion today, implying a pre-money valuation at $34 billion.

“That is not far away from $25 billion what we predicted, certainly a far cry from $100 billion that the market valued just nine months back.”

There’s a hidden message in FB’s continued slide, too, one that could apply to many more stocks. “The example shows that cash is king, and any valuation other than based on cash flows is unlikely to sustain for long,” Srivastava remarked.

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Day 2 of trading for Facebook’s newly minted stock is over, and things didn’t improve quite as people had hoped. Shares of the hyped offering were down nearly $4 from the IPO price of $38, prompting complaints that Morgan Stanley, the lead underwriter, had priced the shares too high. (Usually, you hear the opposite—that underwriters price IPOs too low and reap a windfall in the process.)

Others also grumbled that too many shares were offered, especially after the late addition of 84 million shares. That probably did tamp initial demand, but it still seems like an odd complaint given that just over 15 percent of the company was available for purchase. CEO Mark Zuckerberg also remains still undisputedly in control, as Anup Srivastava pointed out to me earlier this year.

Now that Facebook has finally gone public, check out our previous coverage on the topic.

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Groupon

When the JOBS Act was passed last month, it contained a provision that was largely overlooked. Companies are now allowed to submit confidential drafts of their IPO documents to the SEC. That sounds innocuous enough, but if you remember what happened with Groupon—as the Wall Street Journal does—it feels a bit less innocent.

The problem with Groupon was their accounting measures gave a distorted view of their actual performance. If Groupon had filed after the JOBS Act was passed, the questionable provision of the law would have kept those accounting measures secret until the IPO documents were filed publicly. There would have been no chance for the public to critique Groupon’s documents. That concerns investors and accountants, including Anup Srivastava, an assistant professor of accounting.

“Approximately a year back, we raised concerns about Groupon’s accounting practices. We specifically pointed out problems with Groupon’s revenue and expense recognition policies,” Srivastava said.

“As expected, Groupon has since ‘restated’ its past financial performance, by reporting lower revenues and higher operating expenses. In common terms, when a firm restates its financial statements, it basically conveys, ‘oops, we made a mistake!’ and ‘sorry, you invested in our firms, based on wrong performance indicators!’ ”

Those actions have accountants questioning the wisdom of including the confidentiality provision in the JOBS Act. “Some may argue that Groupon’s example provides confirming evidence against the JOBS Act’s provisions,” Srivastava said. “While we agree with the directional effect, we do not yet have a large enough sample to conduct a systematic study to draw that conclusion.”

While there may not be ample evidence to condemn those provisions at this point, there is evidence for the directional effect to which Srivastava referred. IPOs are happening at younger and younger companies, according to a widely-cited 2004 paper by Eugene Fama and Kenneth French. Furthermore, Srivastava said his own recent research indicates that young companies are investing less in assets with high recovery values, meaning investors are left with little to liquidate if the company fails.

“In that context, the JOBS Act’s provisions, which permit a potential IPO firm a mechanism to avoid a public scrutiny of its accounting policies, seem inconsistent with above research,” he said. “For example, we have raised issues with Facebook’s accounting, since its accounting policies are publicly available. The JOBS Act provisions appear to contradict the spirit of Securities Act of 1933 and Sarbanes Oxley Act of 2002, that detailed disclosures result in greater transparency, greater investor protection, and more efficient allocation of capital.”

Photo by swanksalot.

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Libor logo

Libor is in a spot of trouble. The economic indicator, which stands for London Interbank Offered Rate, is widely watched as a measure of credit risk in the economy. But it has also been the subject of investigations by regulators in the United States, Japan, the United Kingdom, and the European Union. Libor is supposed to be free from abuse, but the investigations suggest otherwise.

First introduced in 1985 by the British Bankers’ Association, Libor influences rates on everything from credit cards to mortgages to financial products. Every morning, a panel of banks submit “bids” that detail the rate at which they feel they could borrow money in various currencies. What gets reported is the interquartile mean, or the average of the middle 50 percent of those bids.

The problem is that the process of submitting those bids is not entirely transparent. Since many financial instruments are tied to Libor, traders at some banks apparently tried to influence the indicator by misreporting their bids to boost their profits.

“Libor is a standard reference rate used to construct and settle trillions of dollars worth of contracts annually,” said Robert McDonald, a professor of finance. “Manipulation of the rate is an embarrassment for the banks and the regulators, will undoubtedly lead to lawsuits, and undermines the integrity of the financial system.”

As such, the BBA is considering changing the way Libor is calculated to avoid similar problems in the future. They say it is part of a regular review of the indicator, but the scandal undoubtedly has something to do with it.

The overhaul is something of a tacit admission that Libor is manipulable, something which BBA has previously denied. Despite that, McDonald says the rethink won’t hurt the measure any more than the scandal already has.

A future without Libor is difficult to imagine. According to a government bond trader interviewed by the Financial Times, “If you want a figure for term interbank rates, you have to use the Libor survey because there are no or very few actual trades.”

Still, if Libor does fall out of favor, McDonald is certain something will take its place. “People would latch onto or construct something,” he said. What’s less certain is what that something will be.

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Much of the buzz surrounding the Facebook IPO stems from its sheer size. With a speculated valuation of $75 billion to $100 billion, it would be on par with companies such as Bank of America ($75 billion), Amazon ($90 billion), and McDonald’s ($100 billion). But do the numbers bear that out? Based on past earnings, speculation would price Facebook at 75 to 100 times earnings, or in the same territory as Google.

Anup Srivastava, an assistant professor of accounting information and management, thinks those numbers are too dear. “My best case scenario valuation is $25 billion,” he said. “This is based on the firm’s revenues reaching approximately $21 billion in ten years’ time from approximately $4 billion today, and the firm maintaining a high return on assets of approximately 20 percent.”

It is difficult to say what exact number the market will bear, but for those who like to speculate, Srivastava has developed a Facebook valuation tool, available in either an interactive web version or a downloadable Excel spreadsheet.

Facebook valuation tool
open in a new window

From an accounting perspective, Facebook isn’t facing the same scrutiny as Groupon, which employed some clever accounting to polish its image. Still, Srivastava is not entirely satisfied with Facebook’s filings.

“I would have preferred to see a detailed break-up of cash flow from operations,” he said. “I would have also preferred to detailed break-up of non-current assets, to examine whether firm is capitalizing any expenditures that it should expense. Net income of exactly $1 billion raises a red flag. It is difficult to achieve an exact number without manipulation. Maybe the firm underachieved the threshold and managed its earnings upward. Maybe the firm overachieved the threshold but deposited some earnings in cookie jars to show higher earnings in future.”

Srivastava offers another cautionary note to prospective investors. “Investors should take into account the deep in-the-money options held by management,” which if exercised could potentially dilute the value of outstanding shares. Furthermore, one share of common stock will have only one-tenth the voting rights of shares held by controlling shareholders, he pointed out. “I do research in this area, and this extreme anti-takeover protection mechanism of dual-class share structure concerns me, because I believe in the motto ‘absolute power corrupts absolutely.’ ”

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Facebook logo

After years of meteoric growth, Facebook will be filing for its initial public offering today. The social network is expected to raise $5 billion, which would value the company at between $75 billion and $100 billion. It’s been one of the most widely anticipated IPOs since Google went public in 2004.

The offering is expected to be a bonanza for investors, though the Facebook itself does not need the IPO for access to capital. “They have absolutely no problems attracting financing when they need it,” said Yael Hochberg, an assistant professor of finance who studies venture capital. “Markets like SecondMarket provide liquidity for divesting of shares, and no company truly relishes the burden of public company reporting requirements and short term pressures from investors interested only in where the stock price went last quarter. For focus on long-term business, they are likely to have been better off remaining private.”

Facebook’s offering was likely prompted because it has more than 500 investors, a threshold which triggers an SEC requirement to disclose its financial statements. Disclosure without a public offering does not offer much benefit for a company, so many go public around that same time.

With the books finally open, we’ll have a better idea of exactly how much money Facebook makes. But by all estimates, the firm has nothing to worry about. Ad revenues for 2011 were estimated at $3.8 billion, Hochberg said, a more than five-fold increase over the previous two years. “Growth in Facebook users seems to be slowing, but growth in monetization of user activity appears to be increasing,” she added.

To the chagrin of privacy advocates, the additional public scrutiny will probably do little to change Facebook’s practices. Google’s experience after its IPO serves as a good model for what to expect, Hochberg said. Though there has been quite a bit of public outcry over changes to its privacy policy, Google’s finances don’t seem to have been affected. Facebook’s real concern, she said, will be employee motivation after the offering. Many will be worth many millions of dollars and will be tempted to leave and start new ventures.

Perhaps the biggest question on people’s minds is Facebook’s eventual valuation. “Is it worth $100 billion?” Hochberg asked. “We’ll have to see the numbers in the filing to get a better idea.” But she is bullish on the Facebook’s outlook. “I think that looking forward, Facebook will continue to grow revenues through advertising—which seems to be very effective when embedded in a social network as Facebook has done—but also through many other channels,” she said. “To me, the key issue here is recognizing that for many people, especially younger users, Facebook is the Internet.”

Photo by Andrew Feinberg.

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Venture capitalist Mark Suster examines the trade-offs between chasing profits vs. pursuing growth.

There is a healthy tension between profits & growth. To grow faster businesses need resources in today’s financial period to fund growth that may not come for 6 months to a year. The most obvious way to explain this is with sales people.

If you hire 6 sales reps in January at $120,000 / year salary then you’ve taken on an extra $60,000 per month in costs yet these sales people might not close new business for 4-6 months. So your Q1 results will be $180,000 less profitable than if you hadn’t hired them.

I know this seems obvious but I promise you that even smart people forget this when talking about profitability.

Hiring more people isn’t always the right answer. You have to understand whether they’re likely to yield revenue growth in the near term OR whether you have access to cheap enough capital to fund your losses until your investments pay off.

Heard through professor of finance Yael Hochberg.

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