Why Facebook's stock is tanking

Facebook was all over the Nasdaq on Friday, but in a disappointing way.

(Credit: Sarah Tew/CNET)

Well, the euphoria over Facebook didn't last long, did it?

I would guess that the enthusiasm over Facebook's stock lasted a few minutes into its first-day trading session, peaking with a rare $45 order that many believe was more of a fluke than a true indication of demand.

Since then, reality has taken hold. The stock opened with a thud, and is down more than 12 percent to $33.56, a sobering reality for anyone caught with Facebook shares on Friday, when the stock closed just above its offering price of $38. (Facebook shares closed Monday at $34.03, down 11 percent.)

So how did the most heavily hyped stock completely fall on its face? There are a lot of reasons: glitches with the Nasdaq system that slowed early orders, an IPO price that got a last-minute bump, and indications of lackluster demand from institutional investors. But the most important is the underlying concern and growing realization that Facebook just isn't worth $100 billion.

"With revenue and (earnings before interest, taxes, depreciation, and amortization) growth decelerating in 2012, we find Facebook's current valuation unappealing," said BTIG Research analyst Richard Greenfield.

That's not to say Facebook won't be worth $100 billion some day, but it doesn't deserve that valuation now. The company still doesn't quite know how to fully take advantage of its huge user base to generate revenue and is still tinkering around with different business models beyond its core display advertisement business.

Numbers don't add up 
Let's look at the 2011 numbers At $38, Facebook's price-to-earnings ratio was more than four times that of Google's 2011 PE ratio. That's despite Google posting revenue and profit that were 10 times higher than Facebook.

"Valuing Facebook is more art than science at this stage of its development and the current state of both social and mobile advertising," Greenfield said.

Business Insider illustrates the issue nicely when looking at estimated 2013 earnings. Apple trades at about 10 times its estimated earnings for next year, while Google has a price-to-earnings ratio of 12. Based on BTIG's estimate and Business Insider's own estimate, Facebook has a multiple of 40 to 100 times earnings.

Still, it's easy to be drawn in to Facebook's story. The company boasts nearly 1 billion users who log in to the site each month, and roughly half a billion who check the site daily. For many people who use Facebook, the social network isn't just a site they visit for a few minutes; many will spend hours logged on.

That's the kind of numbers and engagement advertisers want. The dilemma, however, is people don't go to the site to be bombarded with ads. The display ads that do show up generate a decent amount, but given its large base, Facebook should be generating more revenue.

That's one reason why General Motors pulled its ads, regardless of how well it did or didn't manage its social network presence. Expect other companies to voice similar frustrations.

Google, on the other hand, serves up targeted ads based on what a user searches for, something advertisers and companies are willing to spend bigger bucks on. With a search query, there's often an intent to buy that's not there when you're on Facebook to check on the latest status updates of your friends.

Until Facebook figures a way to similarly serve up relevant ads to people on the site, the company will continue to be bogged down by concerns over its ability to reach its potential.

Its other ventures, including its platform business, a planned app store, and even an idea for promoted posts, could end up generating some additional revenue for Facebook as well, but getting the ad model right is key.

Glitch provides clarity 
The Nasdaq is rightfully taking some heat for how it mishandled the early trading for Facebook, cancelling and delaying orders throughout the day. A few traders and money managers complained about how disastrous the process was on Friday. Nasdaq admitted yesterday that design problems interfered with the Facebook trading.

Some blame the glitches for destroying any momentum Facebook had in the stock. Any interest in placing higher orders was likely squashed amid delays and indications the stock would fall further.

Those delays may have actually saved a lot of investors from buying into a stock that was fated to fall eventually. A cancelled order may have provided some with a chance to take a second, more skeptical, look at the company.

Some clarity was badly needed Friday morning. Bloomberg had tweeted before Facebook began trading that an order at $70 for its shares out of Germany had emerged, further stirring up the hype and excitement. It's probably fortunate for that person the order never went through.

A last-minute change 
Further fueling the hype, and setting up the stock for its eventual fall, was the last-minute decision to raise the IPO range to $34 to $38 from a prior range of $28 to $35 as well as increase the number of shares offered.

For the uninitiated investor, the increased amount of shares suggests higher demand. In reality, it was to accommodate inside investors looking to take advantage of the higher range and dump more stock.

It's not a good sign when the smart investors with the company from the beginning increase the number of shares they want to sell before it goes public.

Down the line, there are still concerns about where the stock will go after the lock-up period ends. A lock-up period is the specified time when insiders are unable to sell their stake in a company that has recently gone public. The typical lock-up period is 180 days, but some Facebook stock is freed up for sale in as little as 90 days.

A look at other top Internet IPOs showed that aside from Google, all of them saw massive declines, with a few not even in existence.

Of course, Facebook still has a lot going for it. And it does have its share of supporters. Wedbush Securities analyst Michael Pachter said in a note to investors today that he expects the stock to jump to $44 in the next 12 months.

But with its business model still in flux and CEO Mark Zuckerberg's promise that the user will come first, perhaps it's a better bet to stay on the sidelines for now.

(courtesy:cnet.com)