Henry Blodget published an open letter to Facebook employees presenting the 'truth' about their stock price. It reminded me of the time that a company I helped to build - Scient - saw its stock take off from $35 to about $120 and then fall precipitously to $1 over a couple of years. During the decline, one employee asked me "Well, how low can the stock go?". It was clear from the confusion that many employees didn't understand what sets the value of a stock, so I thought I'd add something to Blodget's remarks.
First of all, there is no absolutely 'right' valuation for a stock. The stock price at any moment is a reflection of what a willing buyer will pay a willing seller. The buyer is buying with the expectation that the stock price will eventually go up and can be sold at a profit. That means the buyer is making an assessment of the current price of the stock and a prediction about the future price, which can't be known with certainty. So the buyer uses a variety of tools to guess at what is a fair value for the stock today and what it will be worth tomorrow.
Shares of stock represent ownership of a percentage of the assets and future income of a company. Some assets are 'tangible' - the stuff you could reasonably quickly sell for cash. That includes things like the buildings, equipment, land, computers, inventory, and any cash in the bank. You'd think that people would handily agree on the value of the assets and in the case of cash, that's true. But people can disagree on the value of everything else. The land and buildings might be worth more to one person than someone else. So there is room for disagreement on the value of tangible assets. And 'intangible' assets (like the company's brand or the loyalty of its customers) are very hard to value. You can see how different people may come up with different values for the assets.
If people can argue about the value of the assets, the value of future income is a huge guess. Especially if the company is growing quickly. A small increase or decrease in the rate of growth can have an enormous impact on the future income. Competitors may show up, products fail, management leaves, employees can strike. And in a completely new market, like the one FB has created, no one knows how large and sustainable it will be, how much advertisers will be willing to pay, and what the profits on the income will be. Huge uncertainty.
So we start with a lot of guesses as to the value of the assets and future income. To get the share price, we divide that guessed value by the number of shares that can be traded. Like most IPOs, most of the employees (and some of the investors) agreed NOT to sell shares on the first day of trading. You wouldn't want to invest in a company where everybody was cashing out the first day and could take their money and leave. The so-called 'lockup' is meant to retain employees and signal confidence in the future growth of the company. But as the lockups end, more shares become available for trading and if the valuation of the company remains the same, then the share price will fall (because you are dividing a fixed share price by a larger number of shares. During the IPO, FB sold 420 million shares. But from now until Nov 2012, an additional 1.6 billion shares will be released from lockup. Not all those shares will be sold, but the release puts a lot of pressure on the stock price.
IPOs are tricky things. You sure don't want a stock price to plummet quickly as FB's did. It makes everybody who bought at the high price real mad. But you don't want it to increase quickly either. That means that you sold the initial shares too cheaply, plus as new employees come on board, they are getting stock options at the high price and have less opportunity to make money (unless the stock really takes off, like Google's). The best IPOs see a slow and steady gain in stock price over a period of years. Blodget nails it when he tells the FB employees that there is nothing they can do about the stock price and to focus on the products, the customers and the future.
(For more on the basics of business, check out my Business Backgrounder).
