Learning Objectives – Facebook IPO:

• Stock prices reflect expectations about the future
• What a company says they’re going to do or not do can impact what people expect
• Quarterly earnings reports allow a company to disclose its activities and its financial situation

Introduction

This past month, Facebook released their first ever earnings report as a publicly traded company.  The incredible hype and energy around this company’s IPO has now given way to the more sobering work of scrutinizing the company’s operations and ability to make money. If you’ve been following the first two parts of our IP-Uh-Oh series, you’ll recall that part 1 talked about investments being driven by beliefs and part 2 focused on why companies ‘go public’.  In this last part, we look at the point in time when all the ‘guesses’ get put to the test and a company has to report its earnings to its shareholders.

In its short life as a public company, Facebook’s timeline might resemble that erratic but popular friend we all know on Facebook. It would start with pictures of a seemingly epic party that they managed to get invited to and would somehow give way to status updates about lawsuits suggesting that something at the party has gone horribly wrong. Of course, being the internet, there are countless ways in which the unflattering pictures of the post party hangover have been passed around.  Ironically, the company that was built on “shares, is now more responsible for tending to shares of a different variety. Unfortunately for those holding shares, the market seems to have responded less enthusiastically than many had hoped (as of the writing of this article they’re down over 43% year to date).

Given that stock prices are perpetually forward-looking, however, what a company says (or doesn’t say) about its future opportunities is what investors look to for help in deciding whether to stay the course or to get off the boat.

Expectations matter

In many ways the performance of a company in the stock market mirrors how people build trust in the real world.  If a person (or company) makes fantastic claims about being able to ‘revolutionize’ something, they have to be able to meet the expectations they create.  The earnings report is therefore the chance for the market participants to assess whether or not a company can live up to the expectations investors have of it.  In the case of Facebook, the price declines after the earnings report and after the IPO are a clear signal that either the expectations need to change about what Facebook is worth or that Facebook needs to work much harder to impress an increasingly skeptical audience.

How Professional Guessers Decide

When most professional longer term or fundamental investors look at using their capital to invest in a company, they often consider a number of parameters about a company that help them decide whether or not the company would be a sound investment.  One of the most important things that potential investors look at is the company earnings, and whether or not the price they’re considering paying for earnings is reasonable given the risk they’re taking on.

Most publicly traded companies on major stock exchanges in Canada and the US are required to report their earnings on a regular basis in order to disclose how their business is doing to the general public, and more importantly, to their shareholders.  It is often during this time period, sometimes known as “earnings season” that prices in stocks become more volatile, as earnings estimates are met, missed or exceeded.

It’s important to understand that market participants such as value and fundamental investors rely on these earnings reports to help make their decisions.

Often times there are analysts (the “professional guessers”) that focus on a small group (or even just one company) to try to estimate how well the company is doing and then base their investment decisions upon that research.  Because these estimates are “best guesses”, when the actual reports are disclosed to the public, the accuracy of those estimates are tested and the prices of stocks adjusted according to the news reported within the earnings statement and the future guidance (if provided) of the company management. Whether the market participants like what they hear or simply dismiss it ultimately decides the share price.

Buckle your Seat Belts

Investing is tricky business.  Professional speculators attempt to determine what something is going to be “worth” in the future given everything that is true about the world today and by looking to the past for what’s “normal”.  The major challenge, of course, is that the world is constantly changing – often unpredictably and so how reliable those estimates are, and over what period, ultimately determines how successful an investor or trader will be over the long term.

For retail investors it is important to understand that analyst estimates are a best guess.  When companies report their earnings and activities to their shareholders, both analysts and investors can see for themselves what a company has or hasn’t been doing, and depending on the company, may get some insight into what’s coming around the corner.

The example of Facebook’s IPO, the ensuing legal drama, seemingly endless commentaries and price volatility are just a brief glimpse into the many moving parts involved in a publicly traded company.  The price chart on Facebook’s stock also reveals that market participants were less than optimistic after the release of the earnings report  a signal that there is a bumpy road ahead for those who are still on for the ride. Of course only time will tell if Facebook and its investors will continue to stay friends.