Thursday, 6 January 2011

Goldman, Facebook and pricing psychology

Goldman Sachs this week invested in Facebook at the - some say ridiculous - price of $50 billion.

Let's imagine for a moment that the price does not reflect the company's fundamentals. Could it still be rational for Goldman to have done this? We certainly don't associate that particular bank with being taken in by market euphoria.

Certainly they will make money by providing services to Facebook and other investors [FT, may require subscription]. But they could probably have got the same deal at a lower valuation if they really wanted to. This article in the New York Times suggests they don't really care if the value's too high, because they will make their money back by exploiting small investors anyway.

But they may well care. Indeed, there's a reason they might prefer to pay too much for their stake: it will influence future investors to pay more for the shares. We see in many product markets that the customers don't have any clear idea of the "value" of the product - because it is not directly comparable with anything else. Well, the same applies to shares.

Nobody has any real benchmark for the value of Facebook - a profit multiple is the most likely formula, but Facebook's future profits are much less certain even than its current profits, which are pretty vague already. Revenue multipliers are industry-specific and are just an inferior substitute for profit multiples, used for companies with losses or volatile profits.

So how best to decide whether to pay out good money for your Facebook shares? Well, you could do two things:
  • compare it to Ebay and Google (which seems to be the default position in the reporting of this deal, although it makes no sense for anything except Mark Zuckerberg's ego contest with Page and Brin)
  • compare it to the expert valuation done by those clever people at Goldman
What we see is Goldman using one of the most powerful effects in influencing valuations: anchoring.

If Facebook floats at a value of $45 billion, investors will probably jump at it. A 10% discount to the price negotiated by those übersmart Goldman sharks? Great deal!

If it's $75 billion, then that's only a 50% premium to Goldman's private round - still a pretty good price considering there will now be a public market in which to offload your stake.

And if it reaches $150 billion, well, Goldman will be long out of it by then.

So by agreeing a ridiculous price for the stock, Goldman has increased the value of its own stake - though not by quite enough to compensate for the extra money it paid. The real return comes from its increased fee for handling the IPO. Goldman's purchase has substantially increased the value Mark Zuckerberg and the other Facebook investors can expect for their stakes. You can bet it will be well rewarded with a generous IPO fee of - let's say - 6.5%. And if they succeed in pushing up the value of the IPO, that 6.5% will be worth a lot more than it otherwise would be.

So - like an art dealer who bids for a couple of his own paintings to increase the value of the others being auctioned off alongside them - Goldman will come out of this pretty well. And at worst, they can offload their 1% to some grateful clients currently oversubscribing the $2 billion Facebook fund that Goldman is setting up...

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