Recent financial news has been dominated by the initial public offering of Facebook.  Morgan Stanley underwrote the initial offering last week of 400 million shares at an initial price of $38 per share.  This served as one of the most publicized IPO’s in the history of the stock market.  At $38 per share, this created an implicit market capitalization of $104B for Facebook.

This level of valuation is approximately 107 times earnings.  For comparison, Apple’s P/E is approximately 13, and the S&P 500 index is valued at roughly 15 times earnings.  This means that earnings will need to grow dramatically in the near future in order for its current price to be supported by a valuation that regresses toward the market average.

Day 1 of Trading Tells the Whole Story

There were two notable events on the first day of trading that told the whole Facebook IPO story.  The first is that trading was delayed due to a technical glitch, and the second is that Morgan Stanley wrote a large amount of buy orders at $38 near the end of trading to avoid a net loss in price when the market closed.  What this ultimately met is that people who bought in on the first day made exactly zero money, and that feat was only accomplished by a major purchase commitment by the very company who underwrote the stock offering.

Facebook’s Future Business Model

Simple mathematics dictates that Facebook’s earnings must grow by a factor of 8.2 in order to reach a P/E ratio equal to that of Apple, which is roughly in line with the market average.  Thus, Facebook must find some way to generate MUCH higher profits than they do today if they want to avoid a wholesale collapse in their stock price.  Currently, the only path to earnings for Facebook is revenue from advertising.  Many major companies have commented that Facebook advertising is not highly effective, and GM has already announced that they will no longer advertise on Facebook.

The most valuable asset that Facebook has is a massive trove of user data.  It is not difficult to figure out that they will need to sell this data in some manner or form in order to raise earnings sufficiently for their stock price to be justified with a rational valuation ratio.  This means that the company will need to begin aggressively invading the privacy of its members relatively soon if they wish to have any hope of meeting their earnings expectations.

The Smart Money is Already Out

The most compelling story emerging from the first day of trading for Facebook is not who bought, but who sold.  Most of the people who sold shares were the early investors and insiders.  Many of the people and companies who sold a portion of their stake during the initial offering period are highly sophisticated, and frequently referred to as the “Smart Money” of Wall Street.  Thus, one must wonder if they are being intelligent when buying stock that some of the smartest firms in the world are selling as fast as they can.  Some of the key insider and “Smart Money” transactions are as follows:

• Accel Partners: 56 million shares (28% of total stake)
• DST Global: 53 million shares (40% of total stake)
• Goldman Sachs: 33 million shares (50% of total stake)
• Mark Zuckerberg: 32 million shares (6% of total stake)
• Tiger Global Management: 27 million shares (50% of total stake)
• Mail.ru Group: 23 million shares (40% of total stake)

These six sources account for over half of the 400 million shares that were initially sold to the public.  What this proclaims in large, loud, bright letters is that the smart money and insiders have already started to dump their stock in Facebook.  The IPO of Facebook singularly demonstrates everything that investors should be wary of … lots of hype, lack of fundamentals, and a high level of sales by insiders.  Ultimately, the people who are likely to be punished in this situation is the people who read Zuckerberg’s profile Time Magazine and figured that Facebook would be a great stock to own.  These are the people who will continue to be fleeced by the smart money and insiders for the foreseeable future.

And on the next day of trading, Facebook stock commenced a precipitous drop as more people who seek to unload their shares.  In the end, intelligent investors should focus on the things that matter such as fundamentals and sound business strategies.  Every time that somebody claims “This Time It’s Different” you can be almost totally certain that they are attempting to separate you from your money.  This case is no different, even if though is much more blatant.