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Facebook IPO

By on February 13, 2012
Categories: FINANCIAL PLANNING, MARKET NEWS

There has been a lot of buzz in the financial press in the last week about Facebook’s initial public offering (IPO). One of the most interesting articles appeared in the Wall Street Journal on February 4th. It compares an investment in Facebook with an 18th-century mathematical riddle called the St. Petersburg Paradox. In that riddle, one person tosses a coin until it comes up heads, at which point the other participant gets paid and the game ends. The payoff is $1 if it comes up heads on the first toss, $2 on the second, $4 on the third, $8 on the fourth and so on. The potential payoff doubles with each subsequent toss. The riddle lies in how much you should pay to play the game given the structure of the payoff.

Psychologists have found that most people won’t pay more than $20 to play the game given the risk of getting heads in the first few tosses, despite the potential for extraordinary winnings as the game progresses (you win $537 million on the 30th toss). Buying into the Facebook IPO is similar to playing this coin toss game in the sense that the potential payoff is enormous but the game (or continued success, in the case of the company) could end soon. Even the fastest-growing companies can experience reversals in their stock prices in a short period of time, e.g. the 8% one-day drop in Amazon stock last week following their earnings announcement.

At the high end of the price range indicated in the prospectus, Facebook would be valued at $100 billion at IPO. In comparison, another technology high-flier, Google, is currently valued at $190 billion (8 years after its IPO). If Facebook’s valuation increased to $190 billion over the next 10 years, the shares would deliver a 90% cumulative gain or an average annual return of just 6.8%. In other words, the high current valuation limits the long-term potential upside. While investors in Facebook’s IPO could reap rich rewards, the odds would be more in their favor if the initial valuation of the stock were lower. Read more…

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