E Class Action Investor Lawsuit Raises Facebook IPO Valuation Issues

Might a company be sued for pricing its initial public offering too high? Lawsuits filed in 2013 charge that Facebook (FB) set its IPO valuation too high. That headline resurfaced in December 2015 when U.S. District Judge Robert Sweet ruled that he would allow the cases to proceed as class-action lawsuits.

Reuters reports that the plaintiffs are retail and institutional investors who claim they lost money buying Facebook shares at inflated prices. They say their decision to invest was influenced by Facebook’s projected earnings from the mobile device market. Those were later lowered and so, plaintiffs say they overpaid for their stock.

In its May 2012 IPO, Facebook gave itself an $82 billion valuation; that figure calculated by multiplying the shares outstanding by the $38 share price. As the chart below shows, the valuation fell significantly in the secondary market and took more than a year to recover. It climbed thereafter, ending 2015 at $296 billion. [Note: The share price closed 2015 at $105, 2.8X the IPO price. The valuation increased 3.6X because additional shares were issued after the IPO.] 

From a long-term perspective, one might wonder what the problem is, given that it has climbed nicely. But these lawsuits were filed when the market price was below or near the IPO price, when the plaintiffs felt they had paid too much for their stake.

Two mirroring questions emerge from a lawsuit over IPO valuation. How should a company set one? How might investors assess it?

Valuation is important. Yet, remarkably, it isn’t a required disclosure in an offering document. Investors must calculate it. Unfortunately, many don’t know how to, feel uncomfortable doing so or just forget to.

So, central to this lawsuit is something that is both important and undisclosed. That’s ironic. 

Did Facebook fix its valuation too high? That implies there is a “right price”—an unlikely argument. A stock’s intrinsic value has been the holy grail for capital market theoreticians for more than a century—they are still looking. The question also suggests that Facebook breached a duty to investors by setting it “too high”—it had no such obligation.

According to their attorney’s website, the plaintiffs don’t say that Facebook got the number wrong. Rather, they claim that the company wasn’t fair and forthright with information it knew investors used to assess it.  They say Facebook presented projections during its IPO roadshow that it lowered the day after the IPO. Also, that analysts at its underwriters—Morgan Stanley, JPMorgan Chase and Goldman Sachs—cut their earnings estimates during the roadshow and only disclosed it to select clients.

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Moon Kil Woong 2 years ago Contributor's comment

They have a credible argument and it is not the first time investment banks have screwed people over an IPO. The issue over the fact the stock price has risen is not the point. The point is the misinformation and/or rigging in the IPO. Sadly, most IPOs aren't friendly or tailored to small investors but to big investors who get the upper hand. It's a dirty business and I'm glad people are exposing it and hopefully reforming it with lawsuits.

Karl Sjogren 2 years ago Author's comment

Your cynical comment led me to wonder, did anyone with knowledge of the forthcoming reduction in ST projections short the stock? Less cynically, the desire to head off short sellers may be why FB lowered its guidance so quickly.

In any case, the point is that no one knows how to evaluate venture-stage deals. Better valuation data and IPO deal structures that are valuation-elastic, like those VCs get, are promising solutions.

Moon Kil Woong 2 years ago Contributor's comment

One thing that would help is the barring of companies from pushing non-GAAP results onto investors to sell their company. This is especially prevalent with tech companies and should be an outrage to accountants and regulators. It's akin to someone selling tin pots labeled Costco tin pot and then covering up the label and saying they're from Saudi Arabia and 1 in 10 have genies inside.

There is little to no regulation to protect investors these days. Buyers beware. This may be why direct investment in stocks have plummeted to all time lows.

Karl Sjogren 2 years ago Author's comment

There are many non-GAAP figures that can be relevant to a business.. Please provide an example of what you consider to be an inappropriate use of one.

Meanwhile, I'll give you a GAAP figure that is expensive to generate and doesn't provide useful information to any reader of a financial statement that I can think of--stock compensation expense. Theoretically, I don't see why it makes sense to report shareholder dilution an income statement matter. Practically speaking, everyone I can think of adjusts it off in their analysis--evidence that it is not useful. Dilution is relevant but the way GAAP handles this is not helpful.

I share your desire to see stronger investor protections but I believe better valuation data will be more beneficial than a change in accounting standards..

Moon Kil Woong 2 years ago Contributor's comment

If you invest in other countries you will see the adverse effect of heavy stock dilution in closely held companies. It has an effect when abused and that's why disclosure decreases the effect so you don't need to overly concern yourself with US stocks.

David M. Klein 2 years ago Member's comment

Well said.

Irwin Stein 2 years ago Member's comment

This is an example of how the best underwriters let the fact that there was great demand for the shares cloud their judgement.

Sasha Williams 2 years ago Member's comment

Agreed!