By now, we are all aware that it is likely we get the long desired Facebook ($FB) S-1 this week. We finally get to see the financials and more details on the company. Bloggers and pundits will write for the next few months about valuation and what $FB could be worth once it starts trading. The market value of a stock has always been so intriguing to me, as it is the ultimate “wisdom of the crowds”. The market takes all the available public information, crunches some numbers and adds some opinions to shake out at an agreed upon value of the stock. A company’s public market price is the intersection of practicality and theory – let me explain.
Let’s take an example to walk through what I mean. Pretend you were in a room with ~1000 other people, and I announced that the person who guesses the answer to the following question would win a beach house. I’d likely have your attention and you’d take your best shot at guessing. The question is simply, “Guess a number between 1-100 that is 2/3 of what the average of what everyone else will guess”. Pretty straight forward. I’ve asked this question for years to interview candidates and I always care much more about the logic than the answer. Many follow this logic: “Well, assuming an even distribution, the average of 1-100 is 50. Two-thirds of that is ~34. So my answer is 34.” Not a bad guess. But there is a flaw here – if everyone follows that logic, people will answer 34, and 2/3 of that is ~22. Hence, 22 is the best answer. Or is it?
If people in the room follow this logic, they may soon realize that everyone will know to say 22, so the real answer in practice should be 14 (two-thirds of 22). Then, people may realize that this logic can ultimately keep being repeated, taking the answer down to ~1. So the smartest people in the room realize they should say 1 and submit their answer. In THEORY, they are correct. But in PRACTICE, 1 is a horrible answer – not everyone in the room will think that far through the problem and the actual answer will be something much higher (in fact in my practice, the answer tends to be around 30).
This example points out, that sometimes the best math / logic and theory are over powered by the human factor (flaws, emotions, etc). So what’s my point on $FB? My point is that, we are about to see a lot of ink flow on the suggested value of $FB and in the near term trading, it won’t matter. So don’t be surprised by the stock fluctuations over the first week – the “humans” will set the price….
For those looking for a more sane conclusion, take comfort that in the longer term, stocks ultimately trade to their intrinsic value (the net present value of their cash flows) – but it can take some time…
The next few months should be fascinating…..
Robert Peck, CFA
President CoRise Co LLC