Facebook: Price Versus Value

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I have quoted Oscar Wilde before when he said that people “…know the price of everything and the value of nothing” but if you will forgive me I will repeat myself. That particular quote sprung to mind again over the last few days as I watched Facebook (FB) gain over 20% from the November 26th low of $43.55 in a couple of weeks.

 

It seems that this rally was initially rumor driven. I heard that Carl Icahn or some other big player was buying a large stake, then that FB would become an S&P 500 component. One of these rumors was confirmed on Wednesday when S&P announced that FB would not only become a part of the broad market index, most likely replacing Teradyne (TER), but also the S&P 100. For all I know, the other rumor, that Icahn was buying, could also be true, but both things effect the price of FB, not the value. Of course, when trading, price is what counts.


It should come as no surprise that in the London FX market where I worked gamblers were pretty commonplace, and as a result much of the terminology of the racetrack seeped into trading jargon. One such phrase referred to the futility of backing a horse just because the odds were bigger than most people expected. What counted was not getting a great price, but whether the pony actually won or not. As I was told many times “You can’t eat value”.

The trader’s mentality was so heavily inculcated over the years that I had trouble managing my own long term investments. I knew I was supposed to be looking for things with great prospects, but I would confuse short term “value” with long term prospects and pile in when I saw an opportunity such as FB has presented over the last few days. I mean, buying something that was about to go up had to be good, right? Well, no, not if you don’t sell it quickly. In that case, the fact that “You can’t eat value” becomes painfully obvious.

The stock market, or pretty much any market for that matter, has two driving forces that exist concurrently. The first is as a mechanism to arrive at a price as the result of basic supply and demand. As conditions and expectations of future price change, so demand for a stock, and therefore the current price, fluctuates. Stock markets also, however, act as forward discounting mechanisms. Expectations of future performance of the company are baked into the price. When one force dominates for a while, the other often gets distorted, and that, it seems, is what has happened to Facebook or, more accurately Facebook stock.

The fact that a big investor has been buying or that S&P tracking funds will now be obliged to buy the stock has no bearing whatsoever on the future performance of the company. It does affect price though, hence the 20% pop. What this throws out most is the Forward Price to Earnings Ratio (Forward P/E). Forward P/E is, as I have said before, a fundamentally flawed indicator as to a stock’s value as it depends on the accuracy of analysts’ predictions (guesses?) of future earnings. That said it is all we have.

FB’s forward P/E based on yesterday’s close is around three times the average for the stock’s new buddies in the S&P 500, and you should keep in mind that those earnings projections include significant growth expected by analysts. Many would call that into question given the ephemeral nature of popularity in the social media world. I think FB is well enough established now to continue growing, but not necessarily at three times the pace predicted by generally optimistic analysts.

This move in FB has been priced on expectations of price movement, not on any fundamental value of the stock. Traders have (probably rightly for them) chosen to focus on value in the sense that the price is likely to appreciate, rather than value in terms of long term prospects. This is neither new nor rare, but over time, fundamental value has a way of reasserting itself.

Those focusing on the price action in FB don’t care about that, of course, but at this point you should. If you are thinking of joining in at these levels, and are trying to convince yourself that you haven’t missed the boat, be careful. We can easily convince ourselves to ignore possible problems if we feel left out. To quote Wilde once again… “He is really not so ugly after all, provided, of course, that one shuts one’s eyes and doesn’t look at him.”



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , Technology

Referenced Stocks: FB , TER

Martin Tillier


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