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KINGSTON BUSINESS SCHOOL

THE KINGSTON MBA 2012

Project

Author: Benoy Joseph

VALUE FOR NOTHING


An Assessment of Facebook Inc. IPO - Evaluating the Word count:14,980 Impact of Anchor Pricing and Reference Point.

Acknowledgements
This report marks an end to a wonderful one year of MBA programme away from home and family. The learning and development I have gained in this journey is immense. The MBA journey was definitely challenging and has built a platform to face them with tranquillity. This research would not have been a complete without the help and immeasurable support of the following individuals. First and foremost I would like to offer my sincere gratitude to my lecturer and Project Supervisor Professor Giampiero Favato- Head of Department (Accounting and Finance) Kingston University; who has supported me throughout the research with his enthusiasm, his inspiration, and his simple way of explaining things with the smile intact. The time spent with him has always leaded to a lot of new learning and great ideas. Without his support and guidance this project would have never been complete.

The journey would have not been a success without the challenges and competition from my MBA colleagues. I would personally like to thank you all for a great year and being a wonderful cohort. Though our lives will take different direction and we may not see each other at all, but the time spent with you all will always be cherished.

Lastly, and most importantly, I wish to thank my wonderful Parents Mrs Annie Joseph and Hon. lieutenant Mr Joseph PP, my loving brother lieutenant Antony Joseph who were with me through the on and odds of my life. You three are special in every way and I am glad to have family like you. Without your support and kindness this journey would have never been complete. Thank you for always being there and showing me that you really care. I dedicate this project to my parents and my brother as a token to their everlasting love and support.

Project Abstract
This research is based on the field of behavioural finance and analyses the effects of social, cognitive, and emotional factors on the economic and business decision making process which impacts the individuals and corporates.. This has a consequent impact on the capital markets, business valuation and Investor confidence. The paper extensively uses the literature of Nobel Laureate Daniel Kahneman of Anchor pricing and Reference point in the decision making process and demonstrate the impact of the same on the IPO share price of Facebook Inc. The research focusses on the possible anchoring effect generated by the private capital market operation of Facebooks on the IPO share price and consequently, further valuations been done considering it as a Reference point. The research also explains the selfish motives of the venture capitalist and initial investors behind the high priced IPO, as it leads to windfall gains to the early investors. The research is an empirical study into the phenomenon of Anchoring and Reference point in the context of the Facebook Inc.s highly overvalued IPO share price. The research uses case study strategy and is deductive in nature. This research uses Quantitative method, and relies on secondary data to further evaluate the research questions. The analysis reflects that the Anchoring effect on Facebook Inc.s IPO share price cannot be completely ignored. Especially because of the price range of shares in the private trading was almost similar to that of the IPO price. There is no rational behind such a valuation, as it can be quantified using a Discounted Cash flow analysis. It is very clear from the DCF analysis that the assumptions made in order to achieve the IPO share price are not sustainable. On further evaluating the business model of Facebook Inc.,s it is clear that the revenue streams cannot be sustained and with the increasing users the cost streams will be much higher. The research highlights that the private trading share price is considered to be the reference point and the analyst use heuristics in order to achieve a share price of $38 and eventually give Facebook Inc. a valuation of more than $100Bn. Though the anchoring effect is hard to calculate, but the availability of information can reduce the effect of anchoring.

Table of Contents
Chapter I -Introduction: ................................................................................................................ 5 Fig 1: Facebook Inc. Source of Revenue [Source: BTL] ...................................................................... 6 1.1 The Aim:.................................................................................................................................... 7

1.2 Importance of the Study: ................................................................................................................. 7 1.3.1 What is Anchoring? .............................................................................................................. 8 1.3.2 What is Reference Point? ..................................................................................................... 8 1.3.3 What is Private Trading? ..................................................................................................... 8 1.4 Research Structure: ................................................. 9 1.6 Organisational Context: ................................................................................................................ 14 Fig 2: Organisation using Social media Industry wise. ...................................................................... 16 Fig 3: Organisations Industry wise expanding or initiating Social medial usage ............................... 16 Fig 4: Organisations planning to use Social media to drive Innovation ............................................. 17 1.7 Business Model of Facebook: ....................................................................................................... 18 Fig 5: Unique monthly Visitors on Facebook Inc. .............................................................................. 21 Fig 6: World map of social networking sites....................................................................................... 22 Table1: Y-o-Y % Change in Online Advertising Spend by Industry (USA, August 2009).................... 25 Source: Nielsen report, 2009, [http://en-us.nielsen.com/] ................................................................... 25 Fig7: Facebook Inc. Server loans ....................................................................................................... 26 Fig 8: Facebook Business Model. ....................................................................................................... 27 Chapter II-Literature Review ...................................................................................................... 28 Fig 9: Price Discovery in Amazon IPO Bid ........................................................................................ 31 Chapter III-Research Methodology ............................................................................................. 33 Chapter IV-Analysis ................................................................................................................... 35 Fig10: Graph showing the Venture capitalist investment and Facebooks valuation. ........................ 35 Table 2: Initial Investments made by the venture capitalist in Facebook Inc. in Private Market ........ 36 Fig 11: Facebooks Share Trading in Private market: ....................................................................... 37 4.3.1 Key assumptions by analyst behind Facebooks valuation: ....................................... 40 4.3.2 Recent dip in the revenues from 2011 forecast: ........................................................... 40 4.3.3Advertising monetization: ................................................................................................... 40 Fig 11: DCF analysis of Facebook IPO Share Price .......................................................................... 42 Table 3: Facebook Inc. Post IPO RSU Expiration Schedule............................................................... 44

BIBLIOGRAPHY ....................................................................................................................... 50 Appendix I .................................................................................................................................. 55 1.1 1.2 1.3 1.4 Cash Flow Statement of Facebook Inc.2009-2011. ................................................................. 55 Income Statement of Facebook Inc.2007-2011 ....................................................................... 55 Key Ratios of Facebook: 2007-2011 ....................................................................................... 56 Key Statistics of Facebook Inc.2005-2011. ............................................................................. 56 Appendix II ................................................................................................................................. 57 2. GSV capital share price after the purchase of Facebook shares. .................................................... 57 Appendix III................................................................................................................................ 58 3. Facebook Inc. Consolidate Balance Sheet. Source S1 .................................................................... 58 3.1 Facebook Inc. Income Statement: ................................................................................................. 59 3.2 Facebook Inc. Cash Flow Statement:............................................................................................ 60 3.3 Financials of Internet companies and Start up Used to Compare the EPS and for DCF analysis 61 Appendix IV ............................................................................................................................... 62 Research Proposal .............................................................................................................................. 62 1. Introduction: ............................................................................................................................... 65

Fig 1: Facebook Source of Revenue ................................................................................................... 65 Fig2: Cash Flow Statement of Facebook 2009-2011. ......................................................................... 66 Fig 3 Income Statement of Facebook 2007-2011................................................................................ 66 Fig 4: Key Ratios of Facebook: 2007-2011 ........................................................................................ 67 Fig 5: Key Statistics of Facebook 2005-2011. .................................................................................... 67 2. 3. Facebooks Business Model:....................................................................................................... 68 Conflict of Interest: ..................................................................................................................... 68

Fig 6: GSV capital share price after the purchase of Facebook shares. ............................................... 69 Fig 7: Cash flow of GSV Capital FY 2011. ........................................................................................ 70 Fig 8: Corporate investment on Facebook shares in secondary market. .............................................. 71 Fig.9: Facebooks Share price in secondary market as of Mar2012. .................................................. 72 4. 5. 6. 7. 8. What is a secondary market trading?.......................................................................................... 73 What is anchoring and why is it important?................................................................................ 73 Literature review: ....................................................................................................................... 74 Research Methodology: .............................................................................................................. 77 Bibliography ............................................................................................................................... 79

Chapter I -Introduction
This research is carried out further expanding on the ideas and methods of behavioural corporate finance especially focussing on Anchor pricing and Reference point literature by Noble laureate Daniel Kahneman. Majority of research done in corporate finance are based on broad rationality and have subsequent evidence proving the same. The rationale of capital markets and the analyst valuing goods and securities is been challenged. The research emphasises on the factors that impact the decision making process of the analyst and subsequently of managers, investors and the market as a whole usually leading to highly meaningless valuation of companies and stock. Analysts in the capital markets play a major role in deciding the value of a company and its stock. They are expected to carry out an unbiased forecast about the future growth, about the company, keeping in mind the business model and how they can best utilise the opportunities in the Industry and not make decisions that best serve their purpose. The valuations done by analyst and leading banks are considered accurate and blindly adopted by markets and managers. This subsequently increases the probability of false valuation and potential threat of company being overvalued. A recent example of such practise can be seen in the launch of the Facebook Inc. Initial Public Offer (IPO), leader in social media industry. The company was valued at $38 per share, giving them a valuation of $160Bn. This research will be based on this case study, in order to understand the rationale behind such an inflated valuation and the key factors that influenced the analyst predictions. Initial Public offering (IPO), is a practice carried out by companies to attain more capital for expansion of their business. The IPO in the last decade has been very strategic, with a lot of venture capitalist and the companies putting a lot of time and effort to make the best out of the IPO of companies. Generally, there is very little information available publicly about these firms at the time of initial offer to go public. Usually the information is available in the offering prospectus, which has the information about the prices that venture capitalist, investment banks, directors and others paid for their shares in private trading1. However, the relevance of this price to the current valuation of the firm or subsequent market price may differ completely.
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Private Trading is similar to NASDAQ, however less regulated. Sharepost and Second market are the few known private capital markets.

Facebook business model is fairly simple; the revenues mostly come from advertisements on the platform. As shown in Fig 1, however it is difficult to understand whether Facebook Inc. can really count on its revenue from advertisement unlike Google; which has a very advance algorithm and is the pioneer in Online marketing Industry. On the contrary Facebook Inc. has close to 900million active user; this is a very lucrative number for any social media company. However, Data protection act curtails the company from processing any user information. The question remains, as to how do Facebook Inc. were valued at $38 per share and were supported by the underwriters before it went public.

Fig 1: Facebook Inc. Source of Revenue [Source: BTL]

It is not very hard to assume that an informational asymmetry exists between the Issuing Company and potential investors. As Schipper (1989), argues that these conditions favour the firms launching an IPO to manipulate or manage their reported earnings. The financials of Facebook Inc. show a profit margin of ~18%, however the reliability of these are still questionable as most of the reporting has been done before the IPO and it can be incorrect. There are mainly two benefits the issuer can gain with a high offer price, i.e. Share retained by the pre IPO investors, venture capitalist, investment banks etc. are worth more and secondary offers gain huge profits to the company. Perez 1984 and Ritter 1984b have shown empirical evidence that reported earnings is a key factor in determining the initial market value of the IPO.

1.1The Aim:
This research is carried out to establish a new perspective and understanding of the Reference Point, Anchors. Norms and Mixed feeling that may impact the individual choices and judgements. The aim of this research is to demonstrate the Price Pre Initial Public Offering (IPO) private trading had an Anchoring effect on Facebooks highly over valued IPO price. The research further investigates the influence of the Number of web articles; Web reporting, Analyst reports about the share price in the private trading and consequent valuation it gave to the company which acted as a Reference Point in the $38 share IPO share price. As Facebooks IPO can be claimed as a venture capital backed IPO. The report highlights the conflict of interest, that is the influence that Financial sponsors or venture capitalist that operate aggressively in the private trading have their own selfish reason behind the high price IPO of the company. In the further research, using the current available financials of Facebooks from Bloomberg [BTL] as shown in Appendix I, &III; a detailed Discounted Cash Flow analysis will be carried out, in order to understand the key assumptions behind Facebook Inc. $160Bn valuation.

1.2 Importance of the Study:


The recent Facebooks IPO has undergone major criticism, in terms of highly over valued stock. Analyst prediction on the valuation of Facebook Inc. stock cannot be rationalized and hence this study offers a different perspective on how Anchoring and Reference point phenomenon by Nobel Laureate Daniel Kahneman, has influenced the high valuation of Facebook Inc.s IPO share price. This research is highly important because there are no published articles, claiming Facebooks IPO share price being anchored. This is a new perspective and the further research is carried out to demonstrate the same.

1.3.1 What is Anchoring? Anchoring is a psychological phenomenon and deals with behavioural finance of using irrelevant information as a base for evaluating and making estimates of some unknown value or information. Anchoring effects are present in our daily lives and usually happen due to the lack of information about certain things. While anchoring, the subject base their decision on estimates ,events or values which they have prior knowledge about, even though these events may be completely irrelevant or bear no relation to the actual event. As it can be seen Anchoring impacts decision making and hence it does impact businesses. Most of the business decisions are dependent on past data and past information, and anchoring can confound the process of rationally assessing a comprehensive body of information. Past data and trend may cause an early impression to form, that in turn reduces the importance of subsequent data in hand which may contradict with the earlier trend and data, and in return magnifies the importance of the data that support past trend and data. 1.3.2 What is Reference Point? Reference point can be defined purely as a starting point used in the process of Anchoring. As explained earlier about anchoring, to start an anchoring process the subject uses irrelevant information and this information can be usually described as a starting point or reference point in Anchoring. Reference point are very important in Anchoring as they act as the base for the initial estimate of the value of the unknown event and is further built upon various other factors. In business decision making reference point can be past trend or data, which act as a point for the managers to anchor their decisions. 1.3.3 What is Private Trading? A private capital market or private trading engages in sale of securities to relatively a very small number and to selected investors. The typical profile of the investors in private market is of Multinational banks, Mutual Funds, Insurance companies and pension funds. This market typically operates with selected number of investors, the Private capital market such as Second market and Share post are usually not registered with Securities and Exchange Commission (SEC). The companies that sell their shares in capital market are usually private limited companies and are not legally obliged to disclose their financials and the need for a prospectus is waived. The risk profile varies significantly and involves high amount of leverage for the investors.

1.4 Research Structure:


The research is divided into five important chapters: Chapter I: Introduction. This part of the research basically draws the aims and the objective of the study. A brief description is given on the Behavioural Finance phenomenon of Anchor Pricing and Reference Point which will be the foundation of this research. In order to understand the Industry and Organisational context, academic models like PEST and SWOT analysis have been used. Osterwalder business model is used further to understand the future strategic direction of the company, and to further help the discounted cash flow analysis in Chapter IV. Chapter II: Literature Review Literature Review is focussed on the study of Nobel laureate Daniel Kahneman about Anchor pricing and Reference point. The literature review helps to establish an argument on finding that Anchoring happens when a message is frequently repeated though it may be completely irrelevant to the decision at hand, but can influence the decision significantly. The literature also highlights that lack of information can also be a major reason that increases the possibility of Anchoring. Chapter III: Research Methodology The section is purely dedicated to understand how the research will be carried out. This research is an empirical study based on a case study. The data used is secondary in nature, and is collected from various sources like Bloomberg, Secondmarket, Facebook Incs 1 filing etc. Chapter IV: Finding and Analysis The finding highlights that there is conflict of interest within initial investors and the probability of initial investors influencing the IPO share price of Facebook Inc., is high. The share price of Facebook Inc. trading in the private market, seems to have an anchoring effect on the IPO price of Facebook as they seem to be significantly close, however the investor profile in the private market and NASDAQ is completely different and cannot be rationalised. Reflecting on the literature review, it can also be stated the share price in the private market may have acted as a Reference point in deciding the IPO share price of Facebook as the IPO S-

price which was $38, was very similar to the price range of shares in the Private Market which was ~$30-$40. Chapter V: Conclusion The lack of information and heuristics can have detrimental effect on the financial markets, which are highlighted in this section. Though the phenomenon of Anchor pricing and reference point is hard to understand and evaluate, the availability of information can avoid these errors. The capital markets are highly vulnerable of these and can cause severe damage to investor trust and economy. Further research is also suggested to develop a robust valuation mechanism for high growth start-ups and evaluating intangibles.

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1.5 Industry Analysis


1.5.1PEST Analysis: PEST analysis is an important tool in order to understand the industry that the company works in and how it is impacted by various factors around it. PEST analysis is used in order to understand the industry dynamics and how Facebook Inc. will be impacted with the various changes in the Political, Economic, Social and Technological aspects of the Industry. PEST analysis is the best approach as it helps to understand the future context of the social media industry and which will support the assumptions for the discounted cash flow analysis. Political Factors: The key concern being raised by Regulators and Government is the privacy concerns on Facebook Inc., which can impact the company adversely, as it relies highly on using user information to deliver effective and targeted advertisement and this is the key source of their revenues. There are several class action lawsuits against the company which if successful can imply damages worth $15Bn. This could stifle Facebooks ability to collect and use data of its users and will impact the revenue from advertising drastically, which is the only legible source of income for the company. There have been similar concerns in countries outside USA, as a recent allegation by German data protection officials warned Facebook Inc. investors during its IPO that Facebooks operational performance is based on practices which are highly contradicting with the European privacy law. Facebook Inc.is also under major scrutiny with regards to the US tax evasion and may have to pay substantial funds in connection with tax withholding and remittance obligations concerned with the Restricted stock units (RSU) approximately a few months after the IPO filing.(Is further explained in Chapter IV- Analysis) Economic Factors: Facebook over the year has shown strong growth potential in comparison with the other social networking sites. In FY 2011, the companys revenue grew 88% from FY 2010. There was tremendous growth in revenues in FY2009-11 at CAGR of 119%. Google which also holds a large market share in the online advertisement, showed an increase of 30% in FY2011 and its revenues grew at a CAGR of 27% on FY2009-11[As Shown in Appendix I & III]2.
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Facebook Inc. has not published any audited Annual Report, hence data from Bloomberg Terminal is considered for all the key valuation and analysis.

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The strong year on year performance shows Facebooks inherent ability to drive growth, with Facebook Inc. being the market leader and tremendous opportunity lying with it from the relatively underpenetrated market in social media advertising. Facebook Inc. has been successful in maintaining a low expense base, which has enabled it to maintain higher profit margins in comparison to its competitors. The companys operating margin in FY -2011 was 47.4% and net profit margin was at 18% in comparison with Google Inc. which had an operating margin of 30.9% and net profit margin of 25.6% in the same fiscal year. Higher margin of Facebook Inc. compared to its competitors shows a better aligned cost structure. The company , if can maintain a similar low cost structure, in return make its advertisement rates cheaper can develop it as a competitive advantage. This can show significant result, amid the doubt of the effectiveness of social media advertisement. The company can compete better provided it keeps its advertising prices low. Facebook Inc. also enjoys strong cash flow from operations. The companys cash flow margin in FY 2011 was 41.7%, which is significantly higher than that of Google Inc. which had a 38.4% cash flow margin in the same fiscal year. High operating cash flow margin is a strong indicator of Facebooks earning quality, as it indicates the companys efficiency to effectively convert sales into cash. The company was also very successful in converting 12.6% of its revenue into free cash flow. The ratio of free cash flow to sales is a measure to identify the companys revenue from operation transformed to free cash. The strong cash flow generation shows the financial flexibility Facebook Inc. enjoys. Facebook Inc. also faces significant challenges with regards to monetizing its reach and drive revenues together. The strong free cash flow enables Facebook Inc.to grow inorganically through mergers and acquisitions and can also fund its expansion plans at a feasible rate. However, the recent acquisition of Instagram 3 for $1bn shows that Facebook Inc.is trying hard in order to survive and sustain its competitive advantage. The rationale behind this acquisition cannot be justified without the company showing a well-planned and thought out M&A strategy. Facebook Inc. has engaged in a lot of M&A activities in the early 2011, which have not added much value to the social networking giant. The depleting revenues in the Q1 FY 2012, has raised question on Facebooks strategy to sustain its position as a market leader and grow at the same time. The IPO also has made it vulnerable, and with its
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Instagram is a photo sharing social media company launched in 2010 and operates with merely 13employees, and was acquired for ~1Bn cash by Facebook Inc. in April 2012. This acquisition was extremely criticized as the value addition with this deal was very low.

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share price trending negatively from the offer price, has raised questions about the companys future. Social Factor: Facebooks entry into the mobile market with the launch of its new App Centre4 has been a commendable step in order to monetize the vast mobile user base. The access to App centre is like an open source and can also be accessed through Apples IOS and Android OS. Usually the App centre does not sell the mobile apps however redirects it to apps on Android and Apple IOs. This curtails Facebooks scope to generate revenue, as the major control remains with the operating system owners. However, Facebook Inc. promotes social apps that require Facebook Inc.log in credentials, which is a requirement in the App centre. Though it is a mere log in feature, Facebook Inc. has more users using its network. This further enables Facebook Inc.to collect substantial data of its users and can help the company to further expand its database which in turn can be used for its core targeted marketing proposition. Furthermore, Facebook Inc.is planning to sell its non-platform specific apps, or HTML5 apps for a 30% fee on every sale on App centre which is highly dominated by Operating system providers. This approach will end the monopoly enjoyed by the operating system providers and Facebook Inc. can enjoy the access to user activity information to its advantage. If this being capitalised upon properly, Facebook Inc. can be leader in mobile social media experience, a market which is not being explored yet. Technological: Facebooks primary source of revenue is still from advertisements, however the potential of this is yet to be proved due to the inherent business model company adopts. In return, Google is very much prepared to capture the online advertisement market which Facebook Inc. cannot capitalize. Facebook Inc. has constantly engaged in displaying advertisement, keeping in mind it does not disturb the user experience on the portal, and hence they are not being very efficient in generating the potential revenues that they claim. According to a survey conducted by KPMG, Facebook Inc. makes about 1/10th of Googles revenue, though they have two times the page views. The survey also shows that Facebook Inc. lacks in terms of revenues from page views, as Google earns 100-200 times from their page views.

The App centre enables users to find new social apps; it also promotes developers an additional way to grow their apps with Facebook Inc. providing insights to facilitate them successfully.

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1.6 Organisational Context:

1.6.1 SWOT Analysis of Facebook: The popularity and the potential of social media continue to grow, it is not just about connecting with people, but corporates are interested in understanding what customers watch and what they buy. Facebook Inc.is the market leader in the social media industry, especially with the underlying potential in the mobile user market and the emerging economies in the east. SWOT analysis is carried out in order to understand how the companys strategy is designed in order to capitalise on the future opportunities and overcome the threats. This also acts as a strong foundation for the DCF analysis in the later part of the research. Strengths: Facebook enjoys the market leadership in the social media industry with ~800million active users and this definitely favours its operation in this competitive environment. Facebook Inc. enjoys a strong position in the social media industry both in terms of revenue and user base. In comparison to the competition, Facebook Inc.is the market leader in terms of the number of visits and user stickiness. According to the industry report Facebook Inc. has 63.2% of overall visits, and the second best is YouTube at 20.3% and Twitter at 1.7%. This in itself shows the dominance Facebook Inc. has in the industry. Facebooks foray into social media advertisement has proven to show significant improvement in their revenues and has also threatened the market leader Google. The corporates understanding the potential of online advertisement through the social networking sites will further add to the Facebook Inc. market leadership in the online advertisement. Facebook Inc. currently enjoys market leadership in US online advertisement, which combines spending on online video, sponsorships and media advertisement. Facebook is also trying to develop its mobile web platform to accommodate advertisements to cover its mobile user base. This is a market which is not yet explored and has immense underlying potential. However, Facebook Inc. can only capitalize on these opportunities if it has a first mover advantage and it can create and sustain its competitive advantage and market leadership. Facebook Inc. definitely has a competitive advantage with regards to the number of users and the penetration it has acquired so far with new applications and creating room for advertisements, whilst its competitors are still lagging behind.
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Weakness: As discussed earlier, Facebook Inc. has not been very successful in monetising its Mobile user base. The company does not display advertisement in its mobile platforms, which is a huge setback for the company. Out of the 845million active users, 432million are mobile users and the potential revenue it can generate is immense. Google, which is considered to be the biggest competitor of Facebook Inc.in online advertisement, has already entered the mobile advertisement segment and they claim that it has added significantly to their revenues. Google claims that its mobile advertisement revenues grew to over $2.5billion by the third quarter of 2011 [Source: Company reports]. This is definitely a setback for the Facebook Inc. looking at the potential this market can offer and mistakes like these will cost them their competitive advantage over its rivals. The IPO of Facebook Inc. has brought the company under radar and has exposed that the company does not have a very robust business model [Facebooks business model is studied in detail in the next section]. A weak business model and unclear revenue channels have exposed Facebook Inc. further towards legal and data protection laws. Investors have shown concerns over Facebooks unstable share price and it will make it extremely difficult for Facebook Inc.to raise capital for their future expansion. Opportunities: The potential online advertisement has revealed; backed with social media platform is tremendous. The adoption of social media as a medium to advertise is widespread and is still showing growth in the emerging BRIC 5 markets. This again may be attributed to the emerging economies lower dependence on conventional marketing techniques and also to the declining cost of internet access and devices in the developing world. A snapshot of industries using social media can be seen in the Fig 2 below.

BRIC is an acronym used for Brazil, Russia, India and China as they are considered to be in the same stage of economic development.

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Fig 2: Organisation using Social media Industry wise.

The online advertisement spend is expected to increase tremendously, as it is cost effective in comparison to the conventional advertisement channels. The industry estimate shows that the current global advertisement market is expected to be at $25.27 billion in 2012, and is expected to grow by ~ 36% to reach $34.4billion in 2013. It is imperative that the online advertisement industry is going to grow tremendously, looking at the potential it carries. According to the survey conducted by KPMG, majority of businessess are using social media to enhance their relationship with customers , and are also expanding their use of social media to enable growth, through innvoation in their product and services [As shown in Fig 3&4]. The survey highlights, that two third of the respondents say that their organisation are in the process of expanding or intiating plans to exploit social media platform for sales and marketing purpose. Six in ten respondents also said they are using social media for business development and communicating directly with customers for customer service purpose.

Fig 3: Organisations Industry wise expanding or initiating Social medial usage

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Fig 4: Organisations planning to use Social media to drive Innovation

Threats: Facebook is under constant risk from its competitors and also from new start ups. Facebook Inc. weak business model was exposed with it going public. Facebook Inc. will have to create robust plan to show how it is planning on generating revenues. Facebook Inc. Future investment on R&D would be very crucial, as the company will have to make sure it utilizes all the possible opportunities that may come up, and enhance the user experience. New start-ups like Pin interest, Pandora, Instagram etc. cannot be predicted, and Facebook Inc. cannot always be relying on acquiring them as it may be relatively expensive, because of the Facebook Inc. current risk profile it will be even difficult for them to choose debt financing for its future operation and equity financing will further dilute the existing shareholders. Facebook Inc. will definitely be under constant pressure in order to maintain a steady cash flow, as there will be significant amount of R&D expenditure in the near future and the new products which Facebook Inc. can bring to the market will determine their existence. The recent announcement of GM 6, to reduce its advertisement expenditure on Facebook, can also be a major setback for the Facebooks future operations. If corporates are not able to see significant improvement in conversions through social media website or Facebook, they may fall back to the conventional ways of marketing.

General Motors, leader in the automobile industry announced it will stop advertising on Facebook platform, as the paid ads on the platform are not fetching any car sales for the company.

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Legal threat from government and Facebooks obligations under the data privacy act can further curtail the companys growth and possible revenue streams. Tax burden on Facebook Inc. can again be a cause of concern, as a lot of Facebook Inc. pre-tax profit may shrink.

1.7 Business Model of Facebook:


Facebook Inc.s, operation in the dynamic social media industry is commendable. However with the use of a business model, it will be easier to understand the potential revenue streams of the company and will help in further DCF analysis. According to Osterwalder and Pigneur (2002), it is highly necessary to understand and use business model in the highly volatile and dynamic business environment. Rappa (2004) defines a business model as the method of doing business by which a company can sustain itself. While Magretta (2002) explains it as the story which explains how enterprises work. Linder and Cantrell (2000) further explain it as a state the organizations core logic for creating value. Afuah (2004) defines the business model as the framework for making money. Petrovic et al. (2001) consider it as the logic behind a business system for generating value that actually lies behind the business process. However, the most precise argument is by Osterwalder and Pigneur (2002), they explain that the business model is used to inter relate business strategy and business process. They explain the business model as the conceptual and architectural implementation of a business strategy and also a ground work for the implementation of the business process. Customer Relationship within the Platform: Facebook has pioneered the effective use of its Information strategy, which provides the user a very safe, efficient and customized experience. Facebooks information strategy has proved to be very successful in collecting profile information about its users; the contents they are sharing, details of the financial transaction carried over within the website; action tracks taken on the portal, for instance sending gifts, attending an event etc.; access to device and browser information, such as browser type, IP address, location. The use of extensive technology to ensure this information is used to enhance the customer experience has proven to be pivotal behind Facebook Inc.s success. It has also helped Facebook Inc.to monetize from its huge user base, with customising advertisement according to your need and like and not disrupting the user experience. Facebook is continuously striving to improve its user experience, which in turn will build Trust and Loyalty with its users. Facebook Inc. has increased the customisation option, and
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has enabled the users to share their information, in the way they intend to. Facebook Inc. has also been successful in gaining TRUSTe certification7, which gives users the control over the content they share and with whom they share it. Facebook Inc.is focussed on enhancing user experience, by ensuring their users have a safe online experience and capitalize on the social networking opportunity. The brand Facebook is thus becoming strong and valuable. Facebook Inc. is constantly trying to improve on the strong positive network effect and safe SNS portal and in return create long term customer relationship and loyalty. Product Innovation: The Value proposition of Facebook Inc. lies with providing a very effective social networking platform which helps its users to communicate, share information and have an interesting networking experience. Facebook Inc. facilitates sharing information and contents with its social graph, which is a digital mapping of peoples social life and provides an opportunity for users to network and build new connection across the globe. Facebook targets the global audience over 13years of age, who are internet users. In this majority are college students. Facebook Inc. has ~30% of users in US, and 70% are worldwide. Facebook Inc. also has various strategic partnerships with advertisers and application developers. Facebooks capabilities underlies in keeping stable network infrastructure allowing mass data transmission on its portal by various users. The infrastructure carries a robust design which ensures a safe, up-to-date, and user friendly internet platform for sharing contents, in the rapid growing internet traffic. Infrastructure management: Facebook ensures it enhance the user experience, by designing various activities and features in order to suffice different social needs of its users. The design of the web portal enables the user to stay in touch with their friends, meet new people and share what users have been doing, through giving users access to various applications made for entertainment, interaction, content development and ensure privacy.

TRUSTe leading online privacy solutions provider with a broad suite of privacy services to help businesses build trust and increase engagement across all of their online channels.

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Facebook is constantly engaging in various strategic partnerships with various content and application developers to enhance user experience. A list of key partnership is listed below: Microsoft and Facebook Inc. got into a strategic alliance, wherein Microsoft will be the exclusive third party advertising platform for Facebook. Oodle, the second largest classified service provide partnered with Facebook Inc.to power its Marketplace application for online classifieds on Facebook Inc.in 2008. Facebook and Zynga got into a strategic partnership for five years, in order to enable the social gaming feature on Facebook Inc. and expand the use of Facebooks virtual credit through online games developed by Zynga. Since 2007, there is an increasing trend of websites using Facebook Inc. beacon, in order to allow users to share the information available on their websites to their friends and others in their network. This feature has become a massive hit, and it can possibly be a source of potential revenue to the Facebook Inc.in the future. Facebook is known to use open source software and application, which reduces the initial sunk cost and also millions of developers are constantly engaged in improving these applications. Facebooks robust infrastructure management is backed by 2000+ human resources across 12countries. Facebook Inc. also received several rounds of funding from various venture capitalists before it went public. Round one $500,000 from Peter Thiel8 in the summer of 2004; round two 12.7 million dollars from Accel Partners in April of 2005; round three 27.5 million dollars from Greylock Partners leading the round, Meritech Capital Partners participating, and Accel Partners and Peter Thiel increasing their investment in the company; and this January 2012 it raised 1.5 billion dollars from Goldman Sachs and Digital Sky Technologies. [Source: Secondmarket & is further explained in Section IV-Analysis] According to Alex.com statistics, Facebook Inc. is growing both in popularity and scale. Its vast user base is one of the greatest assets with the company. Facebook Inc. has maintained its brand intact, though after the IPO, its brand has faced some financial implication. However, users still like and continue using Facebook.

Peter Thiel is an American entrepreneur, venture capitalist, and hedge fund manager. Mr. Theil was one of the initial outside investors in Facebook Inc, with an investment of $500,000 he acquired a stake of 10.2% in the company.

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Market Considerations: The Social networking industry is flooded with new comers and existing websites, competing against each other for market share. eBiz rank(2011) has ranked 15 most popular on average of each websites global networking traffic, in order they are Facebook, Twitter, MySpace, LinkedIn, Ning, Tagged, classmate.com, hi5, myyearbook, meetup, bebo, mylife, Friendster, myHeritage, and Multiply. However, each social networking website tries to target distinct user groups. Facebook Inc. undergoes direct competition from especially three website, Twitter; which is a micro blogging website, MySpace; mainly focus on personalized social networking experience by driving entertainment, connecting with music, celebrities, movies, and games user love. LinkedIn operates in very niche market, and concentrates on professional networking by enabling users to maintain their business connections. However, Facebook Inc.is still considered to be the industry leader with majority of market share. According to Compete.com9 as shown in Fig 5, below Facebooks monthly unique visitors are above 160million, in comparison with the other social networking sites which are below 50million.

Fig 5: Unique monthly Visitors on Facebook Inc.

Compete.com is a digital intelligence provider, which helps brands to understand and evaluate their internet marketing strategies.

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The threat in front of Facebook, is not its immediate competition but the various other regional social networking sites coming up in emerging economies and in various other countries. for example, QQzone, Renren.com, and kaixin001.com for Chinese, V Kontakte and Odnoklassniki for Russian, Mixi and Gree for Japanese, Tuenti for Spanish, etc. A recent blog trying to understand the market share of the Social networking giant and the spread it has got worldwide, the data was taken from Google trends as shown in Fig:6 below.Facebook still hold the majority of market, it is the market leader in 115 out of 132 countries.This shows the dominance Facebook Inc.has over the social networking industry and it will become crucial once it is successful in monetizing from its resources.

Fig 6: World map of social networking sites.

Technology: Facebook has grown tremendously because of its technology. Facebook Inc.is known to use cheap open source softwares, which in turn helps the company to save the initial sunk cost. Facebooks technology architecture, is a mix of Linux, Apache, MySQL and PHP. Facebook Inc.is also the largest consumer of memcached , which again is an open source caching system and has the largest MySQL database cluster in the world. The Facebook Inc.portal is largely written on PHP, though the elite engineering team of Facebook Inc.has effectively developed a source to progmatically develop PHP codes into C++ to enhance performance benefits. Facebook Inc.also supports multi lingual users, with a unique RPC framework, that is unique and easily ties together the infrastructure services written in any language, running
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on any platform. The company has also succesfully developed a unique search engine which accomodates millions of queries a day, with real time updates. Facebook Inc.is highly dependant on open source softwares, and it also encourages the similar model in its portal. Although Facebook Inc.has progressed in technological from many folds, it has drastically failed to monetize its mobile user base. This is mainly due to the failure of the company to bring in advertisements in its mobile portal. With the increasing mobile user base, the company has to ensure that it develops adequate technology which can improve its business model and help monetize the mobile user base. Financial Aspects: Revenue Stream: Facebooks business model has been evolving since the time of its inception. Facebook Inc.initially started with monetizing on the social network that was built intially. The importance was given to the number of users, the brand Facebook Inc.and the user experience. The oppurtunity to make money from social media advertising was limited then, as business were reluctant to invest in new advertising channel without understanding its true potential. However, early 2010 Facebooks revenue was $2 Bn, and $1.86 Bn came purely from advertising and the rest was through virtual currency bought for playing games on Facebook.The company generates revenue through advertisement on its portals in three different ways. Firstly, advertisement space can be bought on the Facebook Inc.portal.It can be developed by anyone who has basic understanding of appplication development. To create an advertisement, the company or the individual has to make an advertisement, give the name and description of the product, the link where the viewer should be directed to, the target group which the advertiser is looking to focus by age, sex, demographics etc. Further to this, the advertiser can choose from different payment options, it can either be pay per view or pay per click. Finally the advertisement will be displayed on the website and the efficiency can be tracked by using various other websites like Compete.com etc. Secondly, Facebook Inc.has created a social ad page. This facilitates, organisation, businesses, movie companies, start-ups to create their own personalized Facebook Inc.page with adding the specification and contents they need, including photos, videos, music and blogs. The rationale behind this is that consumers can interact directly with organisations and
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organisations can get customer feedback and understand their requirements using an exclusive function of Facebook Inc.called Like. The activities of Facebook Inc.users come in their activity feed, which can be seen by other users in the network and gives the users the options to see it or follow it. It is been proven that this medium if advertisement is more effective in comparison with the conventional advertisement which is more of Push advertisement and less of Pull advertisement. This also is considered to be more powerful because it been referred by the other users in the network and considered to be more reliable. Thirdly, Microsoft investment on Facebook, which was linked to a partnership between both the companies. This partnership gives Microsoft exclusive rights to be third party advertiser on Facebooks platform. During early 2009, Facebook Inc.has also started focussing on the sales of other third party brands and real world goods as branded virtual gifts. Companies offering virtual gifts include: Zynga, American Greetings Interactive, GreetBeatz, Somecards and Real Gifts, Sephora, Mars, Incorporated as well as 1-800-Flowers.com., Dell, eBay, Bud Light, Pizza Hut, Target, Dunkin' Donuts, Starbucks.

According to the Piper Jaffray Report, Social Networking Coming of Age, the market for paid virtual goods is estimated at US$ 1.6 billion in 2009 and will be growing to US$ 2.8 billion by 2012 and this can be a source of potential income for Facebook. In addition to this, Facebook Inc. has started offering its ads in fifteen different currencies, keeping in mind that 70% of their users are from outside US. Facebook has also partnered with Neilsen Company10, on creating awareness about the web content and online advertising and how it will change the consumer behaviour. The Facebooks management expects that this partnership can help them reach the global consumer market to promote advertisement on Facebook.

10

Neilsen is the leading global information and measurement company that enables corporates to understand and evaluate consumers and consumer behaviours across the globe.

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Table1: Y-o-Y % Change in Online Advertising Spend by Industry (USA, August 2009)

Estimated Spend on Top SNS

Y-o-Y Percentage Growth

Social Networking Site

Industry

Aug-2008

Aug-2009

On SNS*

On All Sites

Entertainment Travel Business 2 Business Automotive Health Web Media Software Financial Services Public Services Telecommunications Consumer Goods Hardware & Electronics Retail Goods & Services

$1,097,700 $473,700 $683,400 $1,110,200 $1,131,500

$10,012,800 $2,198,200 $1,941,700 $3,085,800 $2,754,900

812% 364% 184% 178% 143% 139% 128% 98% 93% 89% 75% 56%

40% -11% -8% -26% 8% 30% -29% -10% 13% -1% 8% -47%

My Space Facebook Facebook Facebook Facebook Facebook Facebook Facebook Facebook Facebook Facebook My Space

$11,231,800 $26,855,700 $526,400 $3,233,900 $6,836,500 $1,202,500 $6,415,900 $13,203,100

$12,449,500 $23,550,300 $1,913,400 $654,000 $3,349,200 $1,022,900

$8,101,400

$12,556,800

55%

-12%

Facebook

Source: Nielsen report, 2009, [http://en-us.nielsen.com/]

According to the report by Neilsen company, there is tremendous increase in the online advertisement spend by companies in year 2009 and is expected to grow in the future as well. The Table 1 above shows an increase in advertisement spend by 119% on social networking sites in most of the industry, valuing the 2009 spend to be at $108 million. Facebook Inc.also became the No.1 social networking sites with regards to the advertisemt spend by various industries as shown in the above Table 1. This is also an indicator of the changing trend in advertisements, with industries moving from the conventional marketing methods to marketing online and through social media.

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Financial Aspects:Cost Stream: Facebooks recent expansion has driven up the cost to a great extent. Facebooks expansion need to be backed by further investments in infrastructure and human resources. Facebook Inc.users upload approximately 2billion photos and 14 million videos each month; this in return will increase the demand by the social networking giant for more data centre space and more servers.More data centre and servers mean additional cost to the company, with regards to mainitaining and running them efficiently. This will be a huge sunk cost for Facebook Inc.at the early years of its operations as shown in the Fig7 below

Fig7: Facebook Inc. Server loans [Source: Niall Kennedy, Facebook's growing infrastructure spend, San
Francisco, California, United States, March 29, 2009]

Facebook need for data storage and servers will continually increase and this will add to the cost that the company has to pay. Facebook Inc. also has struggled with its financing options, it was highly dependent on debt financing earlier, and to service interest now has further added to the cost of the company. The most important question is the amount Facebook Inc.is ready to invest to expand its hardware, software and storage space especially when it is struggling to generate revenues.

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Fig 8: Facebook Business Model.

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Chapter II-Literature Review


The industry and organisational context of Facebook Inc. clearly shows the huge underlying potential in the company. However, it is clear from looking at the business model of Facebook that, it is struggling to increase its revenues streams and the increase in the user base has significantly impacted its cost base. Considering the initial analysis conducted in the introduction part, the IPO share price of Facebook Inc. at $38 per share is highly unlikely. In the next part of the research, relevant literature will be critically analysed in order to understand the rationale behind the IPO share price. The aim of the literature review is to critically evaluate the previous research conducted on Anchor Pricing and reference point and understand its possible effect on Facebooks share price during Initial Public offering. The first literature on anchoring and reference points has been by Tversky and Kahneman (1974). Anchoring Effect has been further studied in various other domains as well such as general knowledge by (Chapman & Johnson, 1999; Jacowitz & Kahneman, 1995; Tversky & Kahneman, 1974; Wilson, Houston, Etling, & Brekke, 1996), probability estimates (Plous, 1989), legal judgment (e.g., Chapman & Bornstein, 1996), pricing decisions (Northcraft & Neale, 1987), and negotiation (Ritov, 1996) (for a recent review,see Mussweiler & Strack, 1999). The evidence from the studies helps us substantiate the effect of anchoring on every individual. Anchoring is strong and has a very robust effect. It is proved in the studies that anchoring impacts not only laymen but also experts while making decisions and making judgements in their respective field of expertise. For e.g. accountants (Smith & Kida, 1991), real estate agents (Northcraft & Neale, 1987), and judges (Englich & Mussweiler, 2001). Wilson et al., 1996 has also mentioned that anchoring effect is difficult to avoid even when people are forewarned. An article on Reference Points, Anchors, Norms and Mixed Feeling by Nobel Laureate Daniel Kahneman( 1992), is most relevant to our research in order to understand the effect anchoring on IPO share price of Facebook Inc. and the $160Bn valuation given to the company.

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The author explains that anchoring has significant impact in cases where a provocation or message which is clearly irrelevant and not very informative, nevertheless increases the normality of possible outcome. Anchoring effect provides insight on the regular functioning of the norm theory, where the anchor is included as norm to which a relevant stimulus is compared. This study also highlights the implication of anchoring in the process of negotiation and the most important observation relevant to our research is the observation on the emphasis of frequent repetition as a condition for effective anchoring, the relevant evidence from the study suggest that the subjects impression of a particular range of relevant values is critical. The impact of anchoring effect can also be seen in negotiations, where negotiators mislead their counterpart about their intentions and reservation prices. The high claim and low offer concept is practised in the hope of anchoring the other partys view about the negotiators true position and to produce a biased view about the willingness to make concessions. The researcher argues that the absence of relevant information, can lead to stronger anchoring effect. Another important article on Judgement under Uncertainty: Heuristics and Biases by Amos Tversky and Daniel Kahneman ( 1974), is also of significant relevance to our research. This article has successfully described three important Heuristics that are employed in making judgements under uncertainty: (i) Representativeness: Can be used when individual have to judge the probability of an object or event A belongs to the class of process B (ii) Availability if instance or scenarios: is often useful when individuals are asked to assess the frequency of a class or plausibility of a particular event (iii) Adjustments from an anchor: is useful in numerical prediction when a relevant value is available. Hence Tversky and Kahneman (1974) argue that the anchoring effect is the disproportionate influence on decision makers to make judgments biased toward an initially presented value. As per the classical study of African countries in 1974, the subjects were asked to guess the percentage of African countries in the United Nations and were asked to undergo a spinning wheel exercise in order to predict the effect of anchoring. It was noticed that the median estimate was 25 and 45, for the subjects who got 10 and 64 respectively on the spinning wheel. Hence the authors were able to establish that the anchoring effect is present, irrespective of the starting point (or Reference point) give to the subject, but the subject tries to estimate the result on the basis of some incomplete computation. Another experiment
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conducted was on high school students. Who were given the same numerical expression in ascending and descending orders and were asked to solve it in less than five seconds. The results show that the median estimate for ascending sequence was 512 and the descending sequence was 2,250. Hence the authors could conclude that to rapidly answer such questions, people initially perform a few computations and estimate the product by extrapolation or adjustments. Another key research done by Malcolm Baker and Xin Pan (2009),in their article A reference Point Theory of Merger and Acquisitions, have due importance to the research topic. The research carried on studies the anchoring effect created by the 52week high of the stock price in mergers and acquisitions. The recent high of the stock price acts as a reference point, i.e. the 52 week high. The results of the research show a statistical significance of 52 week high of the stock price on the bidders offer price. The authors have conducted a study on 5135 completed mergers and acquisitions, and they estimate that due to the anchoring on the 52 week high there is value transfer of USD179 billion, or 18% of the premium paid on these deals. The research also studies the success of the deals, and they discover that the success of the deal is increased by 3-4% when the bidders offer price is above the 52 weeks high. The relevance of the research to our study is that any know reference point; in this case the 52 week high price leaves an anchoring effect on any merger and acquisition. Hence it will be interesting to evaluate the effect of secondary market share price on the share price of Facebooks pre IPO launch. Another Key research conducted by Reena Agarwal and Pat Conroy in their article: Price Discovery in Initial Public Offerings and the Role of the Lead Underwriter, shows the impact of Underwriters influence on the price discovery process in IPOs. The researcher study the price quoted by lead underwriters on the pre-opening window explains the large portion of initial returns even for the hot IPOs. An example of Amazon.com IPO is given to explain the pre-opening process. The amazon launched its IPO on May15, 1997 at an offer price of USD 18. The lead manager for the IPO was Deutsche Morgan Grenfell, who started the preopening with a bid at $22.50 and asks at $23.50. The pre-opening quote window was open for close to five minutes, with 116quotes were entered for Amazon by eight different market makers. During the few seconds prior to the closure of pre-opening period the best bid was at $29.75

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and the best ask at $30. We can see a shift in the quotes from $22 to $23 range to the $29 to $30. A graph Fig 9; is shown below in order to understand the theory further.

Fig 9: Price Discovery in Amazon IPO Bid

We can conclude from this study that the lead underwrites first quote acts as a reference point in deciding the price in Pre IPO opening, and eventually that price leaves an anchoring effect on the first day of trading. Though researches argue that it is a practise undertaken by underwrites in order to adjust the offer price. Barry and Jennings (1992) and Schultz and Zaman (1994) argue that first trade price capture most of the initial returns. However, according to this research we can understand that the significant price discovery has already taken place, even before the open trading of shares. All the major research on Anchoring draws the attention to a very discrete influence on human Behaviour, where efforts of deception and deceptive messages can be highly effective in producing mental norms about a particular object or event; these messages may be completely ignored or not accepted at all. Anchors also compete with other sources of information and the effect of anchoring can be very strong in the absence of relevant information.

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In the light of the literature, there are three important aspects that can be drawn: 1: There is significant anchoring impact when a provocation or message which is clearly irrelevant and not very informative, nevertheless increases the normality of possible outcome. 2. The frequent repetition of a particular message can have significant emphasis and raise biases, which in turn can have an anchoring effect on the way an event or an object is judged. 3. Anchors compete with other source of information. Anchoring effect is considered to be much stronger when there is lack of information, and the availability of information can reduce the impact of anchoring to a great extent.

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Chapter III-Research Methodology


This research is an empirical study into the highly overvalued Facebooks IPO share price, keeping the theory of Anchoring by Nobel Laureate Daniel Kahneman as the foundation of the study. The research falls under the positivistic paradigm, and is deductive in approach as the focus is purely to demonstrate any possibility of Anchoring that led to the highly overvalued stock price of Facebook.

3.1 Research Questions:


The research is carried out to demonstrate: Did the Share price of Facebook Inc. traded in the private stock market have an anchoring effect on the Initial public offering share price? Did the reports published by various analyst on web, publication and journals increase the normality of possible outcomes, and led to an anchoring effect on the Facebook Inc. IPO share price.

3.2 Research strategy:


This research is a case study approach, as it explores the phenomenon of Anchoring in the context of Facebooks IPO share price. The case study strategy is highly relevant in this situation as the purpose is to gain a thorough understanding of the possibility of Anchoring in the IPO share price of Facebook. A single case study approach is adopted focussing purely on the case mentioned earlier, as it is unique and provides an opportunity to observe and analyse Anchoring phenomenon in this context.

3.3 Data collection:


This research uses Quantitative method, and would be using secondary data to further evaluate the research questions. Secondary data is the most appropriate for the research as it is not feasible to collect primary data for this research. The data sources are limited in this research as the company has not yet published the audited Annual financial statements. In the further section of the report the DCF analysis highly based on the interim reports published

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by the company and information from various publications and journals. The sources of the data for the financial valuation are mentioned below:

Second Market: Second market is private security market place for buying and selling illiquid assets, including auctionrate securities, bankruptcy claims, limited partnership interests, private company stock, restricted securities in public companies, structured products, and whole loans. There are a lot of companies which start trading in these markets before they go public and launch an IPO.

Share Post: Sharepost is similar to Second market. It is an online platform that connects forward-thinking investors with late-stage venture-backed companies and their shareholders. They engage in the process of managing secondary liquidity and raising primary capital easier and more transparent than ever before for start-ups and companies that have not gone public yet.

Form S-1, the Facebooks registration statement for the IPO, which consist of the consolidated financial statement of the company since FY2009-2011. This is the only source of published financials by the company, as earlier it was operating as a Private ltd company.

The Bloomberg Terminal (Property of Kingston Business School), mentioned in the report as BTL. Analyst report, Trade publications about the Facebooks IPO. Academic papers and researches done on the phenomenon of Anchoring and the impact it has on the various aspects of human behaviour.

The above mentioned data sources help in the research, by substantiating the research objective of demonstrating the effects of Anchoring and Reference point in a new perspective in the context of the case.

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Chapter IV-Analysis
The further research analyses will be carried out in the following order: 1: Understand how the FB shares were traded in the secondary market, the volume, the share price and the investors who bought those shares. 2: With the help of the DCF analysis, try to reach a value of Facebook, with keeping in mind the financial position of the company and the rationale that can be assumed to value Facebook Inc.at $100 billion at $38 a share. 3. If Facebook Inc. share are not worth $38 per share, what may be the key reason that critique the existing valuation. To analyse the research question above, firstly a clear understanding of Facebook Inc. secondary market operation is very important. In order to understand the same a snapshot of the Venture capitalist investments and the valuation it gave Facebook Inc.is shown in the Fig10 below and further to this the investments made by the venture capitalist is shown in the below Table 2;

Fig10: Graph showing the Venture capitalist investment and Facebooks valuation.

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Table 2: Initial Investments made by the venture capitalist in Facebook Inc. in Private Market
Type Capital Amount Unattributed $1.5B Jan 2011 Goldman Sachs Digital Sky Technologies Date Investors

Unattributed

$120M

Jun2010

Elevation Partners

Series D

$200M

May2009

Digital Sky Technologies

Debt

$100M

May2008

Triple Point Capital

Debt_round

$100M

May2008

Triple Point Capital

Series C

$60M

Mar 2008

Li Ka Shing

Series C

$15M

Jan 2008

Europeans Founders Fund

Series C

$240M

Oct 2007

Microsoft

Series B

$27M

Apr 2006

Greylock Partners Meritech Capital Partners The Founders Fund

Series A

$12M

May2005

Accel Partners Mark Pincus Reid Hoffman

Angel

$500K

Sep2004

Peter Thiel Reid Hoffman

Source: Second Market (Private trading market)

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A detailed chart as shown in Fig: 10 will be used to further understand how the shares were traded in private trading and at what price were they being bought by the venture capitalist and other investors. The shares traded in the secondary market and their prices cannot be substantiated using a concrete DCF. These trades a basically venture capitalist investments, into the companies which they think might turn out to be really profitable when they go public. The purchase of high demand share also gives the venture capitalist organisations a boost to their share price. On 27Jun, 2011 GSV 11 capital announced that it purchased a portion of Facebook shares, 225,000 shares at $29.28 per share, which gave Facebook a valuation of $70billion.[Source:www.techcrunch.com]. This not only helped GSV to have a share in the number one social media company, but also the share price of GSV capital increased 21% from~ $9 per share to ~$20 as shown in the Appendix II.

Fig 11: Facebooks Share Trading in Private market:

Source: Secondmarket.com

The chart above indicates the daily price at which the Facebook Inc. shares were traded in the Private market. However, the private market operations are totally different from how traditional stock markets operate. The share being traded in the secondary market is pure venture capitalist investments and cannot be reconciled with a valid discounted cash flow analysis (DCF). Private trades are usually small number, and cannot be compared with NASDAQ or London stock exchange. The risk profile of the participants is totally different unlike that of a regular stock market. A comparison of the Private market Vs. NASDAQ is given below:

11

GSV capital was launched in April 2011, listed in NASDAQ as GSVC engages in growth investing especially in venture capitalist backed private companies.

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4.1 Private Capital Market: A private capital market engages in sale of securities to relatively a very small number and to selected investors. The typical profile of the investors in private market is of Multinational banks, Mutual Funds, Insurance companies and pension funds. As said earlier that the market operates with selected number of investors, the Private capital market such as Second market and Share post are usually not registered with securities and exchange commission (SEC). The companies that sell their shares in capital market are usually private limited companies and are not legally obliged to disclose their financials and the need for a prospectus is waived. The risk profile varies significantly, as the companies offering their share in private market are usually high risk and involves high amount of leverage for the investors. 4.2 NASDAQ: NASDAQ is one of the worlds first electronic stock market, which facilitates stock trading and provides price quotation for more than 5000 actively traded over the counter stocks. The companies trading in NASDAQ are public Ltd companies, which have legal obligation to disclose their financials every quarter and annually. The risk profile of the companies, are entirely different from that of private trading. The companies are much stable and carry both debt and equity financing in tandem. The trading in NASDAQ is highly organised and regulated. The trading volume in NASDAQ is huge, as there are huge amount of buyers and sellers. The stock price fluctuates primarily on demand and supply conditions, Analyst reports and various other factors. NASDAQ consists of mainly two important indexes: i) NASDAQ 100Index ii) NASDAQ composite index 4.2.1NASDAQ 100 Index: Launched in January 1985, the NASDAQ 100 consists of 100 of the largest non-financial companies listed on the NASDAQ Stock Market in terms of total market capitalization. The index represents companies across all various industry groups, including computer hardware, retailers, computer software, telecommunications, and biotechnology.

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4.2.2 NASDAQ Composite Index Launched in 1971, the NASDAQ Composite Index is perhaps one of the broadest based indexes available today. For example, the Index includes over 3,000 securities, much more than the other major stock market indices. The NASDAQ Composite is calculated using a market capitalization weighted methodology. To be included in the Composite, the company must be listed completely on the NASDAQ Stock Market, and have a security type of either: Common Stock Ordinary Shares Tracking Stocks Limited Partnership Interests Shares of Beneficial Interest (SBIs) Real Estate Investment Trusts (REITs), or American Depositary Receipts (ADRs)

Security that are excluded from the Index include closed-end funds, convertible debentures, exchange traded funds, preferred stocks, rights, warrants, units, and other derivative securities.[Source: Investopedia.com ] The difference between both the Private trading market and NASDAQ is significant, and it is definite that the NASDAQ is more rational and Private markets are more gambles. The next step in the research will analyse Facebook Inc. valuation linked to the IPO. A detailed DCF analysis will be carried to understand the rationale behind the valuation and negate the aspects if any of Anchoring and reference point.

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4.3 Valuation of Facebook Inc. IPO share price: It is extremely difficult to value private companies in the high growth phase, as a minor shift in the time period can cause significant shift in the valuation. Usually a comparison is done with the companies of similar profile in the industry to get a better financial valuation. The Facebooks IPO price of $38 was ~60-70X its EPS, which is highly unlikely.

4.3.1 Key assumptions by analyst behind Facebooks valuation: Facebook is a unique social networking site, the one which hold majority of the market share in the social media industry. High revenue growth, positive free cash flow and the business model which has tremendous opportunities to monetizing in the future. Facebooks IPO to an extent had impact of the how successful LinkedIn IPO was, as the share are trading in double digits and shows huge potential in the coming years.

4.3.2 Recent dip in the revenues from 2011 forecast: The revenues have decline in 2011, from 154% growth in 2010, to 87% in 2011. The shift in the industry from desktop to mobile users is assumed to the reason behind a fall in the revenue growth. However, significant improvement is expected in FY2012 onwards, as the platform is upgraded to accommodate quality advertisements and the price per ad is expected to increase as well. The increase in daily active users (DAU) especially in growing economies is a positive sign for the companies revenues; however the ARPU in the eastern geographies is significantly lower than that of the west. The revenue growth is expected to stabilise after Y6, the business will be more stable and adjust to the market conditions.

4.3.3Advertising monetization: The revenue projection of Facebook Inc.is highly in the hope that it will be successful to monetize the revenue through its platform and work out a solution to capitalise from its mobile users. Though the numbers look very positive as the Facebook Inc. currently has ~900 million users that accounts to ~40% of the global online population and this can be a very lucrative number for anyone trying to value Facebook. Facebook advertisement revenue is going to be based on two parameters: i) The number of impressions and ii) charging on e- CPM basis. This is primarily focussing on increasing the prices per advertisement on the Facebook Inc. platform. The company assumes that this will

40

have a significant improvement in their revenue forecast in the near future, however it will all depend on the penetration Facebook Inc. can generate in the coming years. Growth in social marketing is still in its early stages, and it may take time for the advertising industry to promote ads with this concept. Facebook Inc. can capitalise on this new trend if it is successful, as Facebook Inc.is the largest social networking sites and the social ad context have 50% better response through Facebook Inc. platform in comparison of the other networking sites. Social network marketing is a new concept and there is definitely a herd mentality, as many corporates and small businesses are thinking it is essential to be in this drive. The cheaper cost structure of the social media marketing is probably one of the key reasons behind it. Facebook Inc. has definitely being very proactive in ensuring it capitalises on this opportunity and grow in scale compared to the other players in the industry. In addition to this another key revenue stream for Facebook Inc.is through the credit it sells for the online games. Zynga is one the biggest partners with Facebook Inc.in promoting online games through the platform. Though the revenues are marginal in comparison with the online advertisement and selling the online real estate to advertiser, however the potential in this market is huge. This is also a competitive advantage for Facebook, as it is still trying to experiment various other online game providers on its platform and derive huge capital gains from this. These will be considered as the few important factors in the DCF analysis of Facebook Inc; further assumption will be present in Fig11 below. The DCF analysis is purely done in order to understand the assumptions that have gone behind the Facebooks IPO share price.

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DCF valuation model


Planning period 1 2 45.0% 40.0% 35.0% 35.0% 0.0% 10.00% 0.0% 0.0% 2.6% WACC calculator Sensitivity analysis* 45.0% 40.0% 35.0% 30.0% 0.0% 10.00% 0.0% 0.0% 35.0% 25.0% 20.0% 20.0% 40.0% 40.0% 35.0% 35.0% 35.0% 35.0% 35.0% 35.0% 10.0% 10.0% 10.0% 10.0% 0.0% 0.0% 0.0% 0.0% 10.00% 10.00% 10.00% 10.00% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 20.0% 35.0% 35.0% 10.0% 0.0% 10.00% 0.0% 0.0% 20.0% 30.0% 35.0% 10.0% 0.0% 10.00% 0.0% 0.0% 20.0% 30.0% 35.0% 10.0% 0.0% 10.00% 0.0% 0.0% 20.0% 30.00% 35.0% 10.0% 0.0% 10.00% 0.0% 0.0% 3 4 5 6 7 8 9 10 60.0% 50.0% 35.0% 40.0% 0.0% 10.00% 0.0% 0.0% Terminal value FCF t+1

Value Drivers

Sales Growth Rate (SGR%) Operating Profit Margin (OPM % sales) Cash Tax Rate (CTR % of OPM) IFCI (% incr sales) non cash IWCI (% incr sales) Weighted Average Cost of Capital Depreciation (% of sale) RFCI (= depr)

Growth in perpetuity

Fig 11: DCF analysis of Facebook IPO Share Price


3,711.0 3,908.0 0.0 0.0 2,332.00 * ** Equity/Market Cap Debt Cost of borrowing % Cash Tax Rate % Risk free rate % Equity premium % Beta WACC 10.00% 827.0 1432.0 5.0% 35.0% 3.2% 5.0% 1.25 SGR OPM CTR IFCI IWCI WACC Impact -20.0% -12.3% -7.4% -2.7% -1.6% -2.4% 88553.4 38.0
* 10% adverse change of each Value Driver at a time

Inputs (2011)

Sales prior year Cash and marketable securities Market Value of Debt Value of Equity Options Number of shares outsdanding (mill)

Corporate Value Share price

Key valuation assumptions: 1.The WACC is an average as of Linkedin, Yahoo and Google (source: Wiki Wealth), as these companies operate in similar valueproposition 2. OPM, IFCI and non cash IWCI based on 2011 (source S1 report) and Facebook's future plans to invest more in R&D and Infrastructure. Capex ~1.7Bn including leases and generating FcF of $845mn 3. Sales growth as projected by 2011-2017 linear estimate (source: SharePost report), however it will be very volatile in Q1-Q3 of each year and expected to stabilise by Y6. 4.Market Cap and WACC figures will be volatile as well, as the RSU's will play a major role in deciding the share price once the restrction is removed. 5. Cash Tax rate is standard with the US companies, however the changes in the legislation about the online industry may impact the rates. * Current lease obligations less current portion ** Source: SharePost (implied market capitalisation) ***Bloomberg Trading Terminal (Revenue,OPM forecast, WACC)

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4.4 Factors supplementing incorrect valuation of the Facebook Inc.


4.4.1Increasing User growth: It is a non-deniable fact that the number of daily active users DAU and Monthly active users (MAU) are constantly increasing on the Facebook Inc. platform. However, studies have shown that the numbers of fake accounts are significantly high. The strength of Facebook Inc. platform is the social networking experience and users expect uninterrupted experience. The marketing campaigns being launched on the platform may interrupt the user experience, and Facebook Inc. might lose the competitive advantage of user stickiness on its platform, as they may switch to other social networking sites. Facebook Inc. is still not very clear about how it will continue with giving the users the same experience and continue making revenue from advertisement. The ambiguity in the value generation need to be considered and brought into DCF, as the revenue stream may continually shrink, even before the Year6. In the coming year, corporates will definitely be looking the ROI through Facebook Inc., which is not very prevalent now considering the fact that it still in the experiment stage. The recent statement by General Motors (GM), that it does not see potential conversions from Facebook Inc. advertising and reduced the advertisement spend on the website. This is just a glimpse of what majority of corporates might consider doing in the future, if Facebook Inc. fails to ensure that the advertisements on the social networking platform are successful. Facebook generates majority of its revenue from the operations in the Unites States and rest of the world is still under penetrated. This is a great opportunity for the company, as the potential in the new market is huge. However, the online population in eastern and developing economies is still low in comparison to the developed western economies. The growth in the internet will be a major contributor for the growth in social networking industry. This includes getting cheaper internet tariffs and availability of internet in small towns and villages and may take significant amount of time that predicted. The austerity drive in the west will further cripple spends by corporates in advertisement and marketing and will further curtail the forecasted revenues of Facebook. There are concerns over the key value drivers of Facebook, especially in a social networking industry the value drivers need constant up gradation to accommodate the needs and wants of the customer and also to ensure to welcome new users. It cannot be denied that Facebook Inc. has significant contribution in terms of R&D, and innovation in the Industry but with a recent
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acquisitions done by the company of Instagram has shown the company is running behind the learning curve and there are other players in the industry who are coming up with innovative and new ideas which can be potential threat to the sustainability and survival of Facebooks business. Facebook will have to ensure that it dedicates significant time and money on R&D for innovative products and marketing solution; in order to be the market leader. For Facebook to survive and grow it cannot purely rely on the social networking platform, it has to grow new revenue streams within the social networking industry. During the Facebooks IPO on May18, the company offered 421.2m shares categorized as Class A at $38 a share. During the IPO, the company actually sold only 180M class A shares and the remaining 241.2m were from the previous investors, as mentioned earlier who were venture capitalist and large banks which invested in Facebook Inc. through private markets like Second market and Share post. (Source: JP Morgan). However a lot of these shares are yet to start trading and are called restricted stock unit (RSU) as shown in the Table 3 below;
Table 3: Facebook Inc. Post IPO RSU Expiration Schedule

Shares Date 17-05-2012 Event IPO 2623 2623 2623 2623 2623 2623

Additional 421 268 247 1241 124 47

Ending Description 268 M Shares are being held by Selling stockholder excl Mr Zuckerburg ~137M RSUs, 55mm shrs and 55mm underlying options for Mr Zuckerberg 1,223M sh & 18M RSUs 124M sh held by selling stockholders other than Mark Zuckerberg 47M sh held by Mail.ru and DST 421 689 936 2177 2301 2348

Outstanding( in Mn) Shares( in Mn) Public Float (in Mn)

16-08-2012 Lock-up Expiration 14-11-2012 Lock-up Expiration 14-11-2012 Lock-up Expiration 14-12-2012 Lock-up Expiration 18-05-2012 Lock-up Expiration

Source: Company reports &J.P Morgan

Table 3 above shows that the first set of lock up expiration will happen on 16-8-2012, which is right after three months of the IPO. The increase in the supply of Facebook Inc. share can lead to further volatility in the share market and this can lead to major fluctuation in the share price. If Facebooks shares trade below the IPO price for long that is most likely the case this will further lead to investor concerns and lose trust in the organisation. It will also become increasing difficult for the social networking giant to raise capital if it plans to expand further. As the source of equity capital will further increase the liquidity in the company and the debt capital option might end up being comparatively more expensive for the company. This will

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also lead to further changes in the WACC12 and the 10% WACC being considered for the WACC will no longer be applicable. The finding mentioned above gives an understanding that the Facebooks valuation is not backed with any concrete facts or assumption. The assumptions being considered in the valuation can possibly be unrealistic and eventually has helped the company with such a valuation. As mentioned earlier there is conflict of interest within the early investors and the share price. The windfall gains for the initial investors through a high priced IPO is significantly high, and it further adds to reason behind why Facebook Inc. might have come up with such an exorbitant valuation of $38 per share valuing the company at ~160bn. It is also interesting to see the share price of $38, was almost close to the price range of Facebooks share being traded in the private market. As shown in Fig 11 above:, the share price of Facebook Inc.in the secondary market was in the range of ~$34-$40, and as it is already explained earlier the private trading and NASDAQ are entirely different from each other and cannot be compared. The risk profile of the investors is totally different in comparison to NASDAQ. Falling back to the literature of Nobel Laureate Daniel Kanhenman about his study on Anchoring and Reference point, it can be assumed that Facebooks share price in the private market had an Anchoring effect on the IPO price and it acted as a reference point in deciding the IPO Price. The literature clearly describes that reference points are important as the outcome are generally compared to them and are usually coded and further evaluated based on the reference point. Hence it can be assumed that there may have been significant impact of private trading share price, especially because the IPO price was at $38, which is very close to the private trade share price. In reference to the literature review done earlier in the research and referring back to the findings of Noble Laureate Daniel Kahneman, it is evident that the provocation or message which is irrelevant and not informative can also influence the decision maker. In this case, the private trading price of Facebook shares which was frequently being reported in the analyst report and various financial magazines may have had significant influence on the decision

12

WACC is the acronym for weighted average cost of capital (WACC) is the firms cost of capital in which each source of capital(Debt & Equity) are proportionately weighted.

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makers mind. The literature also focuses on the lack of information, which can further enhance the effect of anchoring. In the case of Facebooks IPO the financial information available was limited to the offering prospectus and the rest was mere assumptions that the social networking giant can make significant revenue from the weak business model. The share price in the private trading cannot be reconciled with a valid DCF, which is mentioned earlier in the analysis section. The level of operation varies significantly from that of NASDAQ; and the risk profile of the investors is totally different. Tversky and Kahneman (1974) argue that the anchoring effect is the disproportionate influence on decision makers to make judgments biased toward an initially presented value. Hence it can be assumed that the private trading share price of Facebook, acted as an initial value for the company to come up to IPO share price of $38. Though it cannot be proven with data, but it is a valid assumption in the light of the literature by Nobel laureate Daniel Kahneman. The lack of information before the IPO also plays a significant role in assuming the anchoring effect. As Kahneman., D 1992, argues that when there is lack of information, the effect of anchoring is comparatively higher. The author also claims that in such situations people initially perform a few computations and estimate the product by extrapolation or adjustments. These scenarios are widely present in the Facebooks IPO as there was hardly any financial information available and most of the information available was from sources like Second market and Sharepost which were private markets displaying the private market share price of Facebook Inc. shares. This can further add to the theme of the research to demonstrate anchoring effect on the IPO share price of Facebook. The conflict on Interest within the initial investors is another key reason for the high IPO share price of Facebook. As it is already been discussed that the initial investors were large multinational banks, investors and venture capitalist they had their own personal gains behind the high priced IPO. As Barry and Jennings (1992) and Schultz and Zaman (1994) argue that first trade price capture most of the initial returns, the returns from an high priced IPO can lead to substantial windfall gains for the initial investors. In the case of Facebooks IPO, this was clearly seen as out of 421.2m share being offered in the IPO, 241.2m were of the initial investors. The shares of the employees and other small investors were classified as restricted stock units (RSU) as shown in the Table 3 above. This clearly indicates that the financial sponsors and initial investors push for the initial price to be higher in order to gain maximum profits from the initial sale of shares. However, the market operations further even out the
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value of the share and give a fair price purely on demand and supply of the share units. However, in the case of Facebook Inc. shares, the share value might further deplete once the restricted stock units are allowed to be traded in the stock exchange. This will further increase the volatility and stock price may plummet. The large control of the financial sponsor, venture capitalist and multinational banks are significant in most of the IPOs and especially in Facebook Inc.s. The literature by Malcolm Baker and Xin Pan (2009), in their article A reference Point Theory of Merger and Acquisitions, can also be used to further emphasise effects of Anchoring on the Facebooks IPO. The research talks about the importance of anchoring effect created by 52-week high stock price in mergers and acquisition. This can be related to the Facebook Incs IPO, as it can be claimed that the private trading share price had significant impact on analyst arriving at a share price of $38 for Facebook Inc. Though all the above analyses are purely claims and it cannot be substantiated with relevant information and data. The effect of Anchoring and Reference point on Facebooks Inc IPO is purely a perspective to understand the rationale behind a highly overpriced IPO. The information gathered in the earlier part of the research which included a PEST analysis, SWOT analysis and the business model of Facebook Inc. do not support such a high value for the company.

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Chapter V- Conclusion
The research aim is primarily focussed on demonstrating Anchoring and Reference point effect on the Facebook Inc.s IPO through an empirical study and purely by observation. It is perhaps surprising that after this research it can be assumed that the IPO of Facebook Inc. was importantly shaped by psychological reference point and anchors. But as it can be seen through this research Anchoring effects are easy to generate, but extremely hard to evaluate and explain. It can be clearly seen that the anchoring and reference point phenomenon are very prominent in our day to day life, but are usually ignored due to lack of knowledge and heuristics. The effect of Anchoring and reference point can also be used for personal gain, as it can be seen in the research that venture capitalist and financial sponsors may have influenced the IPO priced due to the underlying gains for them. This practice is prevalent in the capital markets of today, where there are significant biases within the corporates and the analyst further tend to follow what is being reported. However, the effects of anchoring and reference point are purely psychological, but are used with a clear intent to mislead the market. Though it is extremely difficult to calculate the impact that Anchoring and Reference point generate, but the awareness of the same can further help to refine the individuals thinking. The research also highlights that the lack of information is one of the important reasons behind the increase in the presence of Anchoring and reference point. Hence there should be all attempt made in order to understand the reasons behind any event, with collecting more information and staying away from heuristics. There should also be widespread changes in the regulations that promote these activities. In the case of Facebook Inc.; lack of transparency about the Financials of the company led to a highly inflated stock price. The only solutions to these may be further transparent systems which help gather more information about any event and individual staying away from heuristics and follow the more scientific ways of evaluating companies and markets. It is extremely important to create awareness of the impact that anchoring and reference point can bring to the financial market, especially due to the increase in the ecommerce and a drastic change in the companys business model, for e.g. Amazon which does its operation purely over the internet. It becomes extremely difficult for analyst and the market to calculate
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the actual worth of the company and they may fall back on to heuristics. The companies are valued on the intangible and when it comes to pure intangible the assumption may not be always right. This is a cause of further risk and this error in valuation can be a cause of another internet bubble or a crash of ecommerce industry. 5.1 Areas of Further research: The fast growing ecommerce industries and new business like that of Facebook which are purely dependant on the intangible assets are very difficult to be valued. The presence of anchoring and reference point cannot be ignored. Due to the heightened difficulty in valuation and analyst falling back in heuristics may cause significant damage to the financial market. An extensive research will be essential to understand the impact that Anchoring and Reference point generated on the IPO of Facebook Inc. The valuation of internet companies and ecommerce business is getting increasingly important it is mainly because of the presence of intangible in the business. A valuation technique which can measure and sustainability of these new companies and their business models can be very enlightening.

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Kristensen, H., Grling, T. and Gteborgs universitet. Psykologiska institutionen (1997) 'The effects of anchor points and reference points on negotiation processes and outcomes', GOTEBORG PSYCHOLOGICAL REPORTS, 27 . Luehrman, T. A. (1997) 'Whats it Worth', Harvard Business Review, 75 pp. 132-142. PrivCo Report Facebook IPO Valuation Pre-IPO-April 2012,[Online].Available at https://www.secondmarket.com/ (Accessed 12 July 2012) Reitsma-van Rooijen, M. and L Daamen, D. D. (2006) 'Subliminal anchoring: The effects of subliminally presented numbers on probability estimates', Journal of Experimental Social Psychology, 42 (3), pp. 380-387. Repin, D. and Solodukhina, A. (2008) 'Behavioral Corporate Finance: A Survey', . Schber, T. (2008) Buyout-Backed Initial Public Offerings, . State Of The Media (2011) The Social Media Report,[Online], Available at http://www.nielsen.com/us/en/insights/reports-downloads.html (Accessed on 19August 2012) Social Networking Research Report (2012) Facebook [Online] , Available at: https ://www .sharespost. com/research (Accessed 20August 2012 ) Tversky, A. and Kahneman, D. (1974) 'Judgment under uncertainty: Heuristics and biases', Science, 185 (4157), pp. 1124-1131. WordPress (2012) SWOT Analysis of Facebook Inc,[Online], Available http://marketingmix.org/swot-analysis-of-facebook/ (Accessed 20 July 2012) WordPress (2012) PEST Analysis of Facebook Inc,[Online], Available http://marketingmix.org/swot-analysis-of-facebook/ (Accessed 20 July 2012) at: at:

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Appendix I
1.1 Cash Flow Statement of Facebook Inc.2009-2011.

1.2 Income Statement of Facebook Inc.2007-2011

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1.3 Key Ratios of Facebook: 2007-2011

1.4 Key Statistics of Facebook Inc.2005-2011.

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Appendix II
2. GSV capital share price after the purchase of Facebook shares.

GSV capital was launched in April 2011, listed in NASDAQ as GSVC engages in growth investing especially in venture capitalist backed private companies. GSVs strategy is to utilise the private market place like Sharepost and Secondmarket to invest in companies that have great potential in the future. GSVs current portfolio comprises of Social Media, Mobile Computing and Apps, Cloud Computing, Software as a Service, Green Technology, and Education Technology. GSV buys shares in private market place from employees, and early investors and acts as a portfolio manager for people who invest in GSVs shares. The company operates in a niche and believes in enabling investors to be a part of the worlds most innovative and promising companies.

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Appendix III
3. Facebook Inc. Consolidate Balance Sheet. Source S1

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3.1 Facebook Inc. Income Statement:

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3.2 Facebook Inc. Cash Flow Statement:

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3.3 Financials of Internet companies and Start up Used to Compare the EPS and for DCF analysis

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Appendix IV
Research Proposal
MANIPAL UNIVERSAL LEARNING

Value For Nothing


An Assessment of Facebook Inc. IPO Evaluating the Impact of Anchor Pricing and Reference Point.
Benoy Joseph

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Project Abstract: The research is carried out to investigate and analyse the effect of anchoring on the share price of companies, which draws on the tendency to Anchor human thoughts to a reference point- without a logical relevance to the decision at hand. The Facebooks IPO is considered for an empirical study in order to prove the above point. Conflict of interest arises while evaluating the initial investors in the company, as it can be seen that mostly investment banks, large Tech companies and venture capitalist have majority of the shareholding in the Pre IPO secondary market. The literature from the Amos Tversky and Daniel Kahneman (1974), Judgement under Uncertainty: Heuristics and Biases would act as the foundation for research. As it describes the human behaviour of dependability on limited number of heuristics which reduces the complex task of evaluating probabilities and relies on predicting values to simple judgements. Findings: The tendency of humans to rely on the available information to make judgements is evident in this case. As the secondary market share price, and the Facebook IPO price is quite similar. The secondary market price is considered as a Reference point and it is not related to the real valuation of the company.

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Table of Contents
1. Introduction: ............................................................................................................................... 65 Fig 1: Facebook Source of Revenue ..................................................................................................... 6 Fig2: Cash Flow Statement of Facebook 2009-2011. ......................................................................... 55 Fig 3 Income Statement of Facebook 2007-2011................................................................................ 55 Fig 4: Key Ratios of Facebook: 2007-2011 ........................................................................................ 56 Fig 5: Key Statistics of Facebook 2005-2011. .................................................................................... 56 2. 3. Facebooks Business Model:....................................................................................................... 68 Conflict of Interest: ..................................................................................................................... 68

Fig 6: GSV capital share price after the purchase of Facebook shares. ............................................... 57 Fig 7: Cash flow of GSV Capital FY 2011. ........................................................................................ 70 Fig 8: Corporate investment on Facebook shares in secondary market. .............................................. 71 Fig.9: Facebooks Share price in secondary market as of Mar2012. .................................................. 72 4. 5. 6. 7. 8. What is a secondary market trading?.......................................................................................... 73 What is anchoring and why is it important?................................................................................ 73 Literature review: ....................................................................................................................... 74 Research Methodology: .............................................................................................................. 77 Bibliography ............................................................................................................................... 79

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1. Introduction:
Initial Public offering (IPO), is a practice carried out by companies to attain more capital for expansion of their business. The IPO in the last decade has been very strategic, with a lot of venture capitalist and the company putting a lot of time and effort to make the best out of the IPO of companies. Generally, there is very little information available publicly about these firms at the time of initial offer to go public. Usually the information is available in the offering prospectus, which has the information about the prices that venture capitalist, investment banks, directors and others paid for their shares. However, the relevance of this price to the current valuation of the firm or subsequent market price may differ completely. A recent example of such practise can be seen in the launch of the Facebook IPO, leader in social media industry. It is very interesting to see the initial offer that Facebook made of $38, valuing them at $160billon. This research will be based on this case study, in order to understand the rationale behind such an exorbitant valuation. Facebook business model is fairly simple, as they claim they generate revenue from mostly advertisements. As shown in Fig 1 , however it is difficult to understand if Facebook can really count on its revenue from advertisement, unlike Google which has a very advance algorithm and is the pioneer in their field. On the contrary Facebook has close to 900million active user that is very lucrative number for any social media company. However, data protection act clearly indicates that any personal information cannot be processed and Facebook is crippled as it cannot sell its users information. The question remains, as to how did Facebook come up with such a valuation and was supported by the underwriters before it went public.

Fig 1: Facebook Source of Revenue

Consequently, it is not very hard to assume that an informational asymmetry exists between the Issuing Company and potential investors. As Schipper (1989), argues that these

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conditions favour the firms launching an IPO to manipulate or manage their reported earnings. In the further research, using the current information on Facebooks Financial we will be doing a Discounted Cash Flow analysis, in order to understand how much Facebook is worth actually. Below are the key Financials of Facebook from Bloomberg.

Fig2: Cash Flow Statement of Facebook 2009-2011.

Fig 3 Income Statement of Facebook 2007-2011

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Fig 4: Key Ratios of Facebook: 2007-2011

Fig 5: Key Statistics of Facebook 2005-2011.

The financials of Facebook show a profit margin of ~18%, however the reliability of these are still questionable as most of the reporting has been done before the IPO and it can be incorrect. There are mainly two benefits the issuer can gain with a high offer price, i.e. Share retained by the pre IPO investors, venture capitalist, investment banks etc. are worth more and secondary offers gain huge amount of cash to the company. Perez 1984 and Ritter 1984b have shown empirical evidence that reported earnings is a key factor in determining the initial market value of the IPO.
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2. Facebooks Business Model:


Facebook claims to have a very strong business model, with very solid and pure monetization plan in a very unstable environment that requires deep understanding of customers changing behaviours across the globe. Facebook generates its core revenues from displaying advertisement revenues. Facebook enjoys the competitive advantage of pricing control on all its platforms. Another key source of revenue is from customer buying credits, called online currency which is used by facebook users to buy online games and other items. Open graph is another key development by Facebook , which enables users to inform the others in the network about the activities they are engaged in, for eg: listening to music, visiting a restaurant etc. It also helps marketers to segment their customers and customise their marketing efforts according to the customers needs and wants. Facebook has immense scale, with ~800 million users, who are connected to 900million objects on Facebook, i.e. community pages, groups, events etc. More than 30billion pieces of content (Web links, news, blogs, photo albums etc.) are shared each month. Facebook users install 20million applications every day. On an average, 250million users engage with Facebook on external websites. Though the potential in Facebook looks very promising, but the source of revenue is limited to advertisements. With the increase in mobile users to ~200million, Facebook platform needs immediate reforms. However, the current Facebook application for mobile users restricts advertisement and hence the source of revenue is depleting.

3. Conflict of Interest:
Reflecting on the point said earlier, about the windfall gain that pre IPO investors, venture capitalist and investment banks can get with a high priced IPO is highly likely in this case. To substantiate this point further, an example of investment management firm GSV capital will be used. On 27Jun, 2011 GSV capital announced that it purchased a portion of Facebook shares, 225,000 shares at $29.28 per share, which gave Facebook a valuation of $70billion.(www.techcrunch.com). GSV capital bought these share from secondary market like sharepost and secondmarket. This not only helped GSV to have a share in the number one social media company, but also the share price of GSV capital increased 21% from~ $9 per share to ~$20 as shown in the Fig 6 below.

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Fig 6: GSV capital share price after the purchase of Facebook shares.

The rationale behind such a boost in the share price is debatable. However, when looking at GSV capitals financials it is very evident that they dont show a very strong growth potential. A Snapshot of GSV capital financial are shown in the Fig 7 below. GSV capital was launched in April 2011, listed in NASDAQ as GSVC engages in growth investing especially in venture capitalist backed private companies. GSVs strategy is to utilise the private market place like Sharepost and Secondmarket to invest in companies that have great potential in the future. GSVs current portfolio comprises of Social Media, Mobile Computing and Apps, Cloud Computing, Software as a Service, Green Technology, and Education Technology. GSV buys shares in private market place from employees, and early investors and acts as a portfolio manager for people who invest in GSVs shares. The company operates in a niche and believes in enabling investors to be a part of the worlds most innovative and promising companies.

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Fig 7: Cash flow of GSV Capital FY 2011.

GSV capital was just one of the investors in the social media leader, however it is interesting to find that a lot of investment management and technology companies have invested in Facebook . For eg Goldmansachs and Microsoft. Fig 8 below, shows the summary of investments made by corporates. The conflict of interest here is, the part these initial investors play in the IPO pricing before the Facebook could go public. As discussed earlier, the people who benefit from the high priced IPO is the initial investors and the issuing company. However, the research will further investigate the rationale behind share price of Facebook during the IPO. In order to arrive at that it is essential to know at what price was Facebooks share trading in the secondary market. Fig 9,below explains the movement of share price in the month of Mar2012.

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TYPE Secondary Transact. Secondary Transact. Corporate Corporate Secondary Transact. Secondary Transact. Debt/Non-Eq - Debt Series E or greater

DATE Jun-10 Dec-09 Jul-09 May-09 Apr-09 Jan-09 May-08 May-09

Series E Non-VC - Indiv Series D

May-09 Mar-08 Nov-07

Non-VC - Indiv Series D Corporate Series C Series C

Dec-07 Dec-07 Oct-07 Jul-06 Apr-06

TOTAL POST-MONEY INVESTORS INVESTMENT VALUATION $120,000,000 Elevation Partners $90,000,000 Elevation Partners $100,000,000 $200,000,000 Millennium Technology Ventures Saints $100,000,000 TriplePoint Capital $200,000,000 Digital Sky Technologies TriplePoint Capital European Founders Fund Microsoft Accel Partners Greylock Partners Meritech Capital Partners $200,000,000 Digital Sky Technologies $40,000,000 Individual Investors $375,000,000 Microsoft Li Ka Shing Samwer Bros. $60,000,000 Individual Investors $315,000,000 $240,000,000 Microsoft $27,500,000 $25,000,000 Greylock Accel Meritech Peter Theil Accel Peter Theil

Series B

Apr-05

$12,700,000

Second Round

Apr-06

$25,000,000

Series B Series A First Round

May-05 Apr-05 Apr-05

$12,700,000 $500,000 $12,700,000

Accel Partners Greylock Partners Individual Investors Meritech Capital Partners Peter Theil Accel Partners

Fig 8: Corporate investment on Facebook shares in secondary market.

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DATE 03/30/12 03/30/12 03/30/12 03/29/12 03/29/12 03/29/12 03/29/12 03/29/12 03/29/12 03/28/12 03/28/12 03/23/12 03/23/12 03/23/12 03/22/12 03/22/12 03/22/12 03/21/12 03/16/12 03/15/12 03/15/12 03/14/12 03/13/12 03/13/12 03/13/12 03-12-2012 03-08-2012 03-08-2012 03-08-2012 03-05-2012 03-01-2012

PRICE

IMPLIED TYPE VALUATION $44.00 $121,440,000,000 Common $44.50 $122,820,000,000 Common $45.00 $124,200,000,000 Common $43.00 $118,680,000,000 Common $41.00 $113,160,000,000 Common $41.75 $115,230,000,000 Common $44.00 $121,440,000,000 Common $44.00 $121,440,000,000 Common $41.50 $114,540,000,000 Common $41.00 $113,160,000,000 Common $40.50 $111,780,000,000 Common $43.50 $120,060,000,000 Common $42.00 $115,920,000,000 Common $43.50 $120,060,000,000 Common $40.75 $112,470,000,000 Common $42.00 $115,920,000,000 Common $42.00 $115,920,000,000 Common $40.50 $111,780,000,000 Common $41.50 $114,540,000,000 Common $42.00 $115,920,000,000 Common $41.50 $114,540,000,000 Common $42.00 $115,920,000,000 Common $43.50 $120,060,000,000 Common $41.25 $113,850,000,000 Common $41.00 $113,160,000,000 Common $41.25 $113,850,000,000 Common $40.75 $112,470,000,000 Common $43.00 $118,680,000,000 Common $43.00 $118,680,000,000 Common $38.00 $104,880,000,000 Common $43.50 $120,060,000,000 Common

Fig.9: Facebooks Share price in secondary market as of Mar2012.

The share price in the secondary market was trading at the $38-$44 range in the month of Mar12. It can be argued that the secondary market price acted as a reference point, in deciding the share price of Facebook during the IPO. The literature by Kahneman and Tversky 1974 explains the influence of anchor and reference point in judgement and human behaviour.

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4. What is a secondary market trading?


Secondary market can be defined as a market place which is involved in buying and selling of illiquid assets, which includes auction rate, securities, bankruptcy claims, private company stock, restricted securities. Two well know secondary markets are Second market and Share post. Secondary market companies are registered as a broker dealer with Financial Industry Regulatory Authority ( FINRA) and the US security exchange commission(SEC). Second Market and Sharepost work closely with private companies who are interested in selling their shares in the private market place. The companies are given full authority to attract potential investors or institutions to buy their shares. The trade can be controlled and the companies can start and stop trading according their wish and wants. The companies in the secondary market are required to disclose necessary financial information to the potential buyers to prevent information asymmetry.

5. What is anchoring and why is it important?


According to Kanhenman et al., Anchoring and adjustment is psychological heuristics which influence the intuitions of people to access probability. According to this heuristic, individuals starts with an indirectly proposed reference point and make necessary adjustment to reach the given estimate. The first approximation is always linked with the anchor and incremental adjustments are based on additional information. With regards to the case of Facebooks IPO, we propose that there is significant influence of the share price of Facebook in the secondary market, on the current valuation and share price of the company. It can be backed by the literature by Kanhenman et al 1974, on Anchoring and Reference Point.

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6. Literature review:
The aim of the literature review is to critically evaluate the previous research conducted on Anchoring and reference point and understand its possible effect on security trading and share price valuation of companies going public. The first literature on anchoring and reference points has been by Tversky and Kahneman (1974). Anchoring Effect has been further studied in various other domains as well such as general knowledge by (Chapman & Johnson, 1999; Jacowitz & Kahneman, 1995; Tversky & Kahneman, 1974; Wilson, Houston, Etling, & Brekke, 1996), probability estimates (Plous, 1989), legal judgment (e.g., Chapman & Bornstein, 1996), pricing decisions (Northcraft & Neale, 1987), and negotiation (Ritov, 1996) (for a recent review,see Mussweiler & Strack, 1999). The evidence from the studies helps us substantiate the effect of anchoring on every individuals. Anchoring is strong and has a very robust effect. It is proved in the studies that anchoring impacts not only laymen but also experts while making decisions and making judgements in their respective field of expertise. For e.g. accountants (Smith & Kida, 1991), real estate agents (Northcraft & Neale,1987), and judges (Englich & Mussweiler, 2001). Wilson et al., 1996 has also mentioned that anchoring effect is difficult to avoid even when people are forewarned. An article on Judgement under Uncertainty: Heuristics and Biases by Amos Tversky and Daniel Kahneman( 1974), is the most relevant to our research in order to understand the effect anchoring on IPO of Facebook. This article has successfully described three important Heuristics that are employed in making judgements under uncertainty: (i) Representativeness: Can be used when individual have to judge the probability of an object or event A belongs to the class of process B (ii) Availability if instance or scenarios: is often useful when individuals are asked to assess the frequency of a class or plausibility of a particular event (iii) Adjustments from an anchor: is useful in numerical prediction when a relevant value is available. Hence Tversky and Kahneman (1974) argue that the anchoring effect is the disproportionate influence on decision makers to make judgments biased toward an initially presented value. As per the classical study of African countries in 1974, the subjects were asked to guess the percentage of African countries in the United Nations and were asked to undergo a spinning wheel exercise in order to predict the effect of anchoring. It was noticed that the median estimate was 25 and 45, for the subjects who got 10 and 64 respectively on the spinning
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wheel. Hence the authors were able to establish that the anchoring effect is present, irrespective of the starting point (or Reference point) give to the subject, but the subject tries to estimate the result on the basis of some incomplete computation. Another experiment conducted was on high school students. Who were given the same numerical expression in ascending and descending orders and were asked to solve it in less than five seconds. The results show that the median estimate for ascending sequence was 512 and the descending sequence was 2,250. Hence the authors could conclude that to rapidly answer such questions, people initially perform a few computations and estimate the product by extrapolation or adjustments.

Another key research done by Malcolm Baker and Xin Pan (2009),in their article A reference Point Theory of Merger and Acquisitions, have due importance to the research topic. The research carried on studies the anchoring effect created by the 52week high of the stock price in mergers and acquisitions. The recent high of the stock price acts as a reference point, i.e. the 52 week high. The results of the research show a statistical significance of 52 week high of the stock price on the bidders offer price. The authors have conducted a study on 5135 completed mergers and acquisitions, and they estimate that due to the anchoring on the 52 week high there is value transfer of USD179 billion, or 18% of the premium paid on these deals. The research also studies the success of the deals, and they discover that the success of the deal is increased by 3-4% when the bidders offer price is above the 52 weeks high. The relevance of the research to our study is that any know reference point; in this case the 52 week high price leaves an anchoring effect on any merger and acquisition. Hence it will be interesting to evaluate the effect of secondary market share price on the share price of Facebooks pre IPO launch. Another Key research conducted by Reena Agarwal and Pat Conroy in their article: Price Discovery in Initial Public Offerings and the Role of the Lead Underwriter, shows the impact of Underwriters influence on the price discovery process in IPOs. The researcher study the price quoted by lead underwriters on the pre-opening window explains the large portion of initial returns even for the hot IPOs. An example of Amazon.com IPO is given to explain the pre-opening process. The amazon launched its IPO on May15,1997 at an offer price of USD 18. The lead manager for the IPO was Deutsche Morgan Grenfell, who started the preopening
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with a bid at $22.50 and ask at $23.50. The pre-opening quote window was open for close to five minutes, with 116quotes were entered for Amazon by eight different market makers. During the few seconds prior to the closure of pre-opening period the best bid was at $29.75 and the best ask at $30. We can see a shift in the quotes from $22 to $23 range to the $29 to $30. A graph is shown below in order to understand the theory further.

We can conclude from this study that the lead underwrites first quote acts as a reference point in deciding the price in Pre IPO opening, and eventually that price leaves an anchoring effect on the first day of trading. Though researches argue that it is a practise undertaken by underwrites in order to adjust the offer price. Barry and Jennings (1992) and Schultz and Zaman (1994) argue that first trade price capture most of the initial returns. However, according to this research we can understand that the significant price discovery has already taken place, even before the open trading of shares.

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7. Research Methodology:
This research will be an empirical study, based on a case study approach with reference to the initial public offering of Facebook and the proposed overvalued share price and the key reason behind it. The anchoring theory by Kahneman and Tversky 1974 will be used in order to substantiate the claim that there is relevant anchoring effect on the Facebooks IPO price allocation and the reference point being used as the share price in the secondary markets. The research is based on a descriptive case study and will undertake phenomenological methodology as the emphasises is on understanding the dynamics present within a single setting.

Research Aim:
The research objective is to investigate and analyse the effect of anchoring on the share price of companies, which draws on the tendency to anchor human thoughts to a reference pointwithout a logical relevance to the decision at hand.

Objectives:
To analyse and evaluate the effect of anchoring on share price, in reference to the pre IPO sale of Facebooks shares on secondary market. Evaluating the real worth of Facebook using DCF analysis, and arriving at a share price which can substantiate the relevance of the effect of anchoring on Facebooks share price. Evaluate how secondary market operation impacts the share price of companies going public, as the secondary market share price generally become the reference point which then becomes the IPO share price.

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Research Paradigm:
The research falls under a positivistic paradigm, and is an empirical study. The aim here is to go beyond, simply reporting observation and combine extensive research with the detailed study of the impact of anchoring on the Facebooks share price. Anchoring is a complex social phenomena and a case study approach is the most appropriate method to be used.

Research Strategy:
The research is deductive in approach, as we know the key area of concern. The key area to be explored is the relevance of anchoring and reference points on the deciding share price in IPOs. As mentioned earlier in the research aim, we are proposing to substantiate the presence of anchoring and reference point effect on the Initial public offering of the Facebook.

Data Collection:
The data collection will be mostly limited to the observation and interpretation of the secondary data available, as the company has not publicly disclosed its financials. However the business model of the company and the report presented by the analyst will help us to identify the key gaps and help substantiate the relevance of anchoring and reference point theory to the given research.

Data Source:
Share post: A secondary market index which helps to evaluate the trend in the Facebooks shares before the IPO was launched. This website also gives the name of the companies holding majority of stakes before Facebook went public. Bloomberg real time library: Gives stock updates and companies financial information year to date. Academic Papers: Academic papers and journals on corporate finance , periodical reviews, Articles on HBR etc.

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8. Bibliography Aggarwal, R. and Conroy, P. (2000) 'Price discovery in initial public offerings and the role of the lead underwriter', The Journal of Finance, 55 (6), pp. 29032922. Arkes, H. R., Hirshleifer, D., Jiang, D. and Lim, S. (2008) 'Reference point adaptation: Tests in the domain of security trading', Organizational Behavior and Human Decision Processes, 105 (1), pp. 67-81. Baker, M., Pan, X. and Wurgler, J. (2009) A Reference Point Theory of Mergers and Acquisitions, . Cervone, D. and Peake, P. K. (1986) 'Anchoring, efficacy, and action: The influence of judgmental heuristics on self-efficacy judgments and behavior.', Journal of Personality and Social Psychology, 50 (3), pp. 492. Chen, Z. and Wilhelm Jr., W. J. (2008) 'A theory of the transition to secondary market trading of IPOs', Journal of Financial Economics, 90 (3), pp. 219-236. DuCharme, L. L., Malatesta, P. H., Sefcik, S. E. and Soffer, L. (2001) 'Earnings management: IPO valuation and subsequent performance', Journal of Accounting Auditing and Finance, 16 (4), pp. 369-400. Embedding, A. (1992) 'Valuing public goods with the contingent valuation method: a critique of Kahneman and Knetsch', Journal of Environmental Economics and Management, 23 pp. 248-257. Epley, N. and Gilovich, T. (2006) 'The anchoring-and-adjustment heuristic Why the adjustments are insufficient', Psychological Science, 17 (4), pp. 311-318. Frederick, S., Kahneman, D. and Mochon, D. (2010) 'Elaborating a simpler theory of anchoring', Journal of Consumer Psychology, 20 (1), pp. 17-19. Kahneman, D. and Tversky, A. (1979) 'Prospect theory: An analysis of decision under risk', Econometrica: Journal of the Econometric Society, pp. 263-291. Kristensen, H., Grling, T. and Gteborgs universitet. Psykologiska institutionen (1997) 'The effects of anchor points and reference points on negotiation processes and outcomes', GOTEBORG PSYCHOLOGICAL REPORTS, 27 .

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Reitsma-van Rooijen, M. and L Daamen, D. D. (2006) 'Subliminal anchoring: The effects of subliminally presented numbers on probability estimates', Journal of Experimental Social Psychology, 42 (3), pp. 380-387. Tversky, A. and Kahneman, D. (1974) 'Judgment under uncertainty: Heuristics and biases', Science, 185 (4157), pp. 1124-1131. www.sharepost.com [Online] Accessed on 15 June 2012 www.techcrunch.com [Online] Accessed on 15June 2012

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