Facebook, Inc. The Initial Public Offering Niranjan Zende

Prof. Trevor Larkan FI 627 Bentley University July 7th 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-on-

Year 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% 45.6%

Groupon GRPN 3-Nov-11 $20.00 $621 million 43.0% 21.3% -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 %chg QoQ. Quarter Capital raised ($B) %chg QoQ.

Q1'04 339 Q1'04 29

Q2'04 385 14% Q2'04 33 14%

Q3'04 339 -12% Q3'04 29 -12%

Q4'04 457 35% Q4'04 39 34%

Q1'05 327 -28% Q1'05 29 -26%

Q2'05 409 25% Q2'05 39 34%

Q3'05 364 -11% Q3'05 38 -3%

Q4'05 452 24% Q4'05 74 95%

Q1'06 360 -20% Q1'06 39 -47%

Q2'06 473 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 2011 2012E 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E Termina

l

DCF Base year

1 2 3 4 5 6 7 8 9 10 year

Assumptions: 7.6% 7.6% 7.6% 7.6% 7.6% 0.0%

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 10,183

14,256 19,959 26,425 32,979 38,651

42,362

43,209

44,073

EBIT 1,695 2,318 3,167 4,325 5,903 8,051 10,377 12,599 14,353

15,279

15,123

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 0.9004

0.8107 0.7299

0.6572 0.5917 0.5357 0.4877 0.4465

0.4111

0.3806

0.3806

PV of FCFF and TV 357 412 471 534 598 1,070 1,668 2,341 2,998 3,526 58,128

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 Equity Debt Preferred

Capital

Value of common equity 69,425.7 Market values $81,247.8

$1,587.0

$- $82,834.8

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%

Exhibit 4

Extract from Consolidated Balance Sheets

Consolidated Balance Sheets: As of March 31, 2012

Pro forma for stock options

Pro forma for stock options +

IPO Cash and marketable securities $3,910 $3,910 $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

Total stockholders equity 5,272 5,597 11,998

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.