Facebook’s IPO will be the largest ever for an Internet company, expected to raise more than 10 times as much as the $1.67 billion raised in GoogleInc.’s 2004 IPO. At the end of the day, the company will be valued at more than $104 billion, and existing stockholders will collect nearly $6 billion.
I have just one question about all of this: Why?
If we turn the volume down on the hysteria for a moment, it’s not difficult to see that Facebook is ridiculously overvalued. For context on that point, consider this partial list of companies that the social media site will be worth more than after its IPO:
Kraft Foods ($66 B)
ConocoPhillips ($97 B)
Pepsi ($103 B)
Disney ($77 B)
Amazon ($93 B)
UPS ($76 B)
Comcast ($80 B)
Boeing ($55 B)
And that’s just a short sample of a very, very long list. All of the companies mentioned are established titans with time-tested brands. Facebook, on the other hand, is barely eight years old and makes its money using a business model brimming with limitations. Namely, it (1) sells advertising on its site, and (2) collects royalties from third party software developers that create content with its platform.
Yes, Facebook has 900 million users worldwide, and yes it’s the most used social media service by a wide margin. But I have yet to hear any analyst say that they think Facebook can effectively monetize all of those users and reach its revenue goal. The talking heads are placing a $50-60 billion (actual) market value on the social media upstart, and some are saying even that’s too optimistic.
“But look at Google!” some say. Sure, Google is an incredible success, but Facebook to date has not shown that it can effectively compete with Google outside of the social media arena. Any argument that it will is speculative at best, and the track record so far better supports an argument that Facebook is reaching its limit while Google continues to innovate.
On top of that, general investors agree that the stock is overvalued. An AP-CNBC survey found that of average Americans who invest in the stock market, 58 percent think Facebook’s valuation is too high at around $100 billion. Only 3 in 10 investors called the expected value fair.
If that’s all true, then why is Facebook still positioned to be the fourth biggest IPO in history?
The answer is woven deep in human psychology — no matter the evidence, we just can’t seem to stop ourselves from inhaling the euphoria until it blinds us. We stumble into a set of cognitive biases that collectively wield impressive power.
The first is Availability Bias, and its corresponding effect, the Availability Cascade. Facebook is exciting, dynamic, and forever in the public eye, and our attention is drawn to it every single day (for some, every hour of every day). We’ve become enamored with Zuckerberg’s creation because it’s so available to us, and collectively we’ve fueled a skewed belief that it is larger than life.
Next is Optimism Bias, which as the name implies leads us to overestimate outcomes with very little reason for doing so. This is partly due to the availability cascade described above, but also because the nuts and bolts of how Facebook makes its money is invisible to most people. Because it’s so much a part of our lives, we assume that it’s a money making juggernaut.
Finally, we have good ole’ Selective Perception. We selectively focus on what we think we know about Facebook–that it’s a phenomenal force of nature–which sends expectations of value sky high. As well, perception is slanted if you’re looking at Facebook through your Google glasses.
Altogether, these biases keep the frenzy going, and the energy of the frenzy feeds an appetite to gamble big. Throw in the human tendency to focus on short term rewards (aka Hyperbolic Discounting), and you have all the makings of a financial disaster.
The irony is that the people driving the demand for this stock have access to all of the information they could ever want to make a sound decision, and that would seem to undercut these biases. And yet, the demand is, to quote one analyst, “obscenely high.” So much so that Facebook raised its per share price simply because it could.
When Facebook falls short of expectations, and it will, investors who stick in beyond the rush will look back on this period of euphoric insanity and wonder why they fell for it. But that will be the wrong question. The right question is why do we keep falling for it. Sadly, few will wait around for an answer — the next big thing will already have their attention.