Back in May, Facebook offered shares of its stock for $38 in its initial public offering (IPO), confident that the sheer number of Facebook users—all 800 million of them—would be enough to power the stock higher.
After three months on the market, it's clear that Facebook and the bankers who were backing it were very wrong.
Facebook stock is currently trading below $20 a share, and there are fears that the stock could go even lower. Its steep drop also makes Facebook the second-worst performer since January 2011. The first? Another social media company, game maker Zynga.
The failures of Facebook and Zynga are reminiscent of technology companies that failed when the dot-com bubble burst more than a decade ago. Both IPOs were surrounded by hype and an underlying belief that they provided a chance to make a lot of money in a short period of time. But once on the market, it became clear that these companies were overvalued, and the price of their stock fell quickly.
It's not just large institutional investors who have been hurt by Facebook's sharp decline. According to reports just after the IPO, mom-and-pop investors lost $630 million in the days following the initial sale. If these investors still hold the stock, they have lost even more.
Wall Street is now split on whether Facebook will be a success. In June, after assessing the company a month after the IPO, a majority of analysts at major investment houses ranked the stock a "hold" rather than a "buy." The period in which Facebook employees were prohibited to sell stock is coming to an end, so many could cash out, flooding the market with shares. Until Facebook can prove it can generate consistent revenue, these ratings are unlikely to change.
The Facebook IPO is likely to serve as a warning to other social media companies considering going public. It should also serve as a warning to retail investors, who need to be wary of buying into the hype around social media.
"The act of taking companies like this public is now tainted. That process is under some scrutiny," says Nick Westergaard, founder of Brand Driven Social, a marketing firm that helps companies maximize their online brand.
What went wrong? Facebook's initial decline was due to a number of factors, including trading glitches that played a part in spooking investors into a sell-off. But the stock's continued downfall is due primarily to the fact that the company has yet to prove it can make money. Right now, its only real value is in the number of people who use it. Until these users can use Facebook in a way that makes the company money over the long term, it will struggle.
According to Westergaard, a company like Google makes money because it has a pay-per-click advertising model. Facebook employs something similar, but it has yet to generate revenues that justified its initial high stock price.
Then there's the question of the company's future. Facebook transformed the way people exchange information. But technology changes quickly, and social media is evolving. There is no guarantee people will use Facebook a decade from now.
Westergaard also says Facebook's leadership did a poor job of outlining long-term goals. "It's up to Facebook's leadership to define the company. I don't think they've been very effective on that," he says.
Lessons for retail investors. It's unlikely that many other social media companies will go public in the short term, given how spooked Wall Street and the public are over Facebook. But inevitably down the line, excitement will build, investors will line up, and a social media company will have an IPO. Should retail investors buy the hype?
The Facebook IPO offers concrete lessons for investors. First, look at the leadership of the company. Are they prepared to be transparent? Do they understand how to manage a publicly traded company?
"Maybe it takes a different type of leader to run a publicly traded company," says Dov Hirsch, senior director of corporate communications for Alana Health Care and a frequent commentator on social media. "A lot of social media companies have young leadership. They're not investor-relations managers. What they do is the opposite of that."
"For these emerging companies, they need to be looking at whether or not they're ready to be publicly traded, whether they have the leadership in place," he adds.
Next, investors should look at the company's plans to generate revenue. Does it plan to make money through advertising? Does it plan to offer a product or service at some point in the future?
Take Twitter, for instance, a company that has yet to go public but is rumored to be considering it. Like Facebook, it already has millions of users and is growing quickly. Also like Facebook, it is an innovative way to share information and is trying to develop models to generate revenue. But if Twitter were to go public, potential investors should consider what the company will be producing in 10 years. Will people be sharing information in a new way in a decade? Will Twitter even be relevant?
Finally, if you're not investing in a company that provides a product or service, understand what makes it unique. Does it have the ability to change and adapt? Or it is just a fad, like MySpace?
"With Facebook, you're not investing in the existing business. You're investing in the potential," says Hirsch. "You're not investing in a product you can look at and touch and feel or a service. You're investing in 800 million people."