Be Aware Of The Facebook First-Day Trap

| About: Facebook (FB)

Stock prices, like most prices, are a function of supply and demand.

The supply is the amount of equity available for sale in the company. The company's capital structure determines its supply. If a company has high debt, it has lower supply because there is a smaller portion available as equity. Similarly, if the company has a number of preferred shares or places limits on its common stock, the supply is limited. The key regarding supply is the amount of the underlying business that the company is offering to the public.

The demand is the amount of money willing to be invested in the stock at a given price. The demand is a function of the company's balance sheet, business model, and market cap.

Let's say investors value a company's assets at $300 million, liabilities and preferred equity obligations at $900 million, and the underlying business at $1 to $1.2 billion. That gives the company a market cap in the range of $400 million to $600 million.

The market cap of the company will be the highest valuation where the amount of money invested in the company is equal to the market cap. Suppose 10 people with $100 million think the company is worth at least $600 million, 15 people with $200 million think it's worth at least $500 million, 20 people with $300 million think it's worth at least $450 million, and 100 people with $1 billion think it's worth at least $400 million:

The company's market cap will be $450 million: $450 million invested at a $450 million valuation. In the real market, there are thousands of investors with varying amounts of money and price targets on each stock. This smooths the demand function into an exponential curve. An actual demand curve might look like this:

All demand curves are not shaped the same. The slope and concavity in a demand curve depend on the riskiness and potential upside of a stock. A REIT or bond offering or fixed-income security will have a relatively flat demand curve, because there is not a lot of variance in the future return on investment. A growth stock will have a demand curve with a higher peak and a lower valley, because predictions of earnings have a higher range.

Facebook (NASDAQ:FB) is offering about 12% of its shares in an IPO.

By offering a smaller number of shares to the public, Facebook takes the demand curve slices the money needed to be raised to determine its market cap:

At its IPO, the price of Facebook will be artificially higher than the market demand for its shares. That does not mean that Facebook's shares will be overvalued, because value is a longer-term equation. But on day one, the shares will trade for higher than market would price them under ordinary supply and demand circumstances. Selling shares with a low float is common for IPOs, but in 2011 and 2012 we are seeing lower than average floats for social media IPOs. LinkedIn (NYSE:LNKD), Facebook , Pandora (NYSE:P), Angie's List (NASDAQ:ANGI), Yelp (NYSE:YELP), Groupon (NASDAQ:GRPN) and Zynga (NASDAQ:ZNGA) have averaged a first-day float of about 10%, lower than the 20-25% historical average for IPOs. Groupon came in the lowest at 6%.

Short selling

Short selling can bring prices down even when there is limited supply. But short selling costs investors more than buying does: short sellers must keep cash on hand to cover an abnormal rise and prevent a margin call. The more volatile a stock, the more cash is required. In addition, on the first day of an IPO it is difficult to short a stock. These factors will keep Facebook artificially inflated for the first day of trading.

If you believe the demand curves, there are two ways to trade Facebook: try to get in early on day one and sell at the end of the day, or avoid the stock altogether. The first method is risky because it will be difficult to purchase the shares before the general public pushes the price up, but it could be rewarding. The second method is safer for long-term value investors. I will probably put in a buy order with a price just above than the IPO to see if I can snag a few shares for cheap, then sell by the end of the day. If my order is not filled, I will stay out of Facebook altogether.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I may initiate a position in Facebook on the first day of trading, and sell at the end of the day. Unsure at this point.