By David Larrabee, CFA
As lawyers and regulators sift through the wreckage of the recent Facebook IPO, the media has been equally consumed with figuring out what went wrong and who was responsible for what was undoubtedly the most overhyped and mismanaged public debut of a company in decades. Amid the finger pointing, the timeless value investing principles espoused by Benjamin Graham and David Dodd seem more relevant than ever.
In 1934, Graham and Dodd wrote Security Analysis, a seminal work that is widely considered to be the “bible of value investing.” Graham’s The Intelligent Investor (1949), derived from his earlier collaboration with Dodd, targets the lay investor yet covers many of the same concepts first introduced in Security Analysis, including intrinsic value, margin of safety, and the distinction between investment and speculation.
Looking at Facebook (FB) through the lens of Graham and Dodd leaves us with a few notable take-aways:
Intrinsic Value — According to Graham and Dodd, the intrinsic value of a security is “that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses.” In other words, intrinsic value is the present discounted value of expected future cash flows. Acknowledging that it was an “elusive concept,” Graham and Dodd nevertheless saw the calculation of intrinsic value as critically important to the analytical process, adding, “It only needs to establish either that the value is adequate — e.g., to protect a bond or justify a stock purchase — or else that the value is considerably higher or considerably lower than the market price.”
The task of valuing young growth companies carries with it unique challenges, including limited operating histories. In the case of Facebook, well in advance of its IPO there seemed to be a fixation on it achieving a $100 billion market valuation but little interest in justifying such a price tag through careful analysis. Earnings of $1 billion in 2011 and promises of spectacular growth seemed to be enough. However, even a cursory look at its recent financials show sequentially declining quarterly revenue growth over the past year. For a valuation predicated on maintaining a prior record of hyperbolic growth, such a slowdown should concern Facebook investors.
A discounted cash flow (DCF) analysis relies on forward-looking assumptions that are prone to error, and overestimating growth rates is a common pitfall. Graham called for prudence when it comes to projecting future cash flows for growth companies, warning that “the market has a tendency to set prices that will not be adequately protected by a conservative projection of future earnings.” In a DCF analysis of Facebook, one would have to make grand growth assumptions to come up with values approaching its IPO price of $38. Facebook may well end up being a great stock to own, but at $38, it seemed to be priced well above its intrinsic value with little margin for error.
Margin of Safety — The margin of safety principle, as advocated by Graham and Dodd, calls for investors to seek stocks selling at a discount to their intrinsic value. Despite being known as the “father of value investing,” Graham acknowledged that growth stock investors could indeed find a margin of safety, but this margin was dependent on conservative projections and prices paid. In the case of Facebook, news that underwriting analysts were lowering estimates during the IPO road show, following disappointing first-quarter results, seems to indicate projections had been excessively optimistic. Likewise, when underwriters raised the offering price to $38, from an original range of $28–$35, well above any conservative estimate of intrinsic value for the shares, it appears that Facebook also failed the margin of safety test.
Investing versus Speculating — Graham and Dodd drew a sharp distinction between investing and speculating. An investment, they proposed, is an operation that “upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.” In the Intelligent Investor, Graham further explained:
The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices. Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high price levels at which he certainly should refrain from buying and probably would be wise to sell.
It’s pretty clear that speculation, not investing, was the driving force behind trading in Facebook’s IPO. Facebook sold 421 million shares to the public in its initial public offering, and 570 million of its shares traded on the first day of trading, meaning the shares saw 135% turnover in one day. Of course, such speculative behavior isn’t unusual when it comes to IPOs. Investors have come to expect that underwriters will gauge demand and price an IPO so as to ensure an opening day “pop” in the price. However, lead underwriter Morgan Stanley badly misjudged demand, and buyers of Facebook shares soon learned that momentum works both ways. The frenzy to buy shares of Facebook, followed by an equally furious and almost immediate stampede out of the shares, is a stark reminder of the difference between investing and speculation.
With that in mind, would Graham and Dodd have clamored for shares of Facebook? Not very likely.