ANTHONY H. CATANACH JR. is an associate professor in the School of Business at Villanova University, as well as the Cary M. Maguire Fellow at the American College Center for Ethics in Financial Services. His professional experience includes five years as an audit manager with KPMG and six years in the financial services industry. Dr. Catanach has received numerous awards for his publication, teaching, and curriculum innovation efforts. He has authored numerous articles on a variety of accounting, finance, and management issues, as well as several business education texts..
In our February essay “Facebook Gets an ‘A’ in Financial Reporting,” the two of us discussed what we liked about the firm’s S-1 filing. We felt that Facebook demonstrated financial reporting transparency and didn’t attempt to buff up earnings with any nonsense about EBITDA or similar metrics. Revenue recognition seems simple and appropriate. Operating cash flows are reasonably reported and healthy. We did not detect any special items, off-balance sheet transactions, or puffery. Further, the Beneish model revealed a very low probability of accounting “manipulation.”
Facebook recently issued its stock, and it ain’t going well. During the first full day of trading, “Investors Pummel Facebook,” as the Wall Street Journal called it. The stock price dropped an amazing 11 percent that day. It lost another 9 percent on the second day.
Several readers are asking us if we want to retract our previous column. They seem to interpret the plunging stock price as evidence that something is wrong in the accounting—that the firm’s financial reporting is not what it should be or lacks transparency.
The answer is that we still hold our opinions as expressed in February. The way to understand the accounting and the current stock price movements is to be sure to distinguish financial statement analysis from valuation. While there is clearly a relationship between the two, as the efficient markets hypothesis asserts, the relationship is by no means automatic or always rational. That’s because, for whatever reason, the stock market tends to overreact to news.
The stock market tends to overreact to unexpected good news by bidding up the price of common shares too high. A good earnings report should drive up the prices to some new equilibrium, but when it goes too high, there are opportunities to cash out one’s profits. Similarly, the stock market tends to overreact to unexpected bad news by driving down the price too far. For example, a bad earnings report can lower prices too much, thereby creating buying opportunities.
One must separate accounting and reporting issues from investment decisions. One should employ financial statement analysis to assess an appropriate equilibrium price. Investment decisions then focus on whether the stock is under-priced or over-priced.
What may now be going on with Facebook is that investment bankers and Facebook managers overhyped the stock. They may have oversold its value. The market has responded by suggesting that the initial price was too high.
What is happening in the market does not change our opinion. Facebook’s accounting and financial reporting appears fundamentally sound. We remind the reader, however, that we did point out two issues raised by the registration statement, and they remain concerns.
The first is with the corporate governance structure. Facebook utilized a “controlled company” exemption so that it does not have to have a majority of independent directors. This is troubling because truly independent board directors are needed in today’s world to rein in potential managerial excesses. Without such controls, managers are not so easily monitored.
The second concern is that stock-based compensation is relatively high. When an entity has a lot of stock-based compensation, we realize that managers may have perverse incentives to use accounting shenanigans to drive up stock prices merely to enrich themselves.
In conclusion, yes, we still give Facebook an “A” at this time for its financial accounting and reporting. But we also completely understand the market’s reaction in adjusting prices given all of the IPO hype.
This essay reflects the opinion of the authors and not necessarily the opinions of The Pennsylvania State University, The American College, or Villanova University.
J. EDWARD KETZ is an associate professor of accounting in the Smeal College of Business at Pennsylvania State University. He has a bachelor’s degree in political science, a master’s degree in accountancy, and a Ph.D., all from Virginia Tech. Professor Ketz has been a member of the Penn State faculty since 1981. He also has taught at the University of Connecticut and the University of Maryland. Professor Ketz has authored and edited 17 books including Hidden Financial Risk (Wiley, 2003) which examines the corporate culture and the institutional setting that engendered recent accounting scandals. Dr. Ketz has been cited in the popular and business press, including The Wall Street Journal, The New York Times, The Washington Post, Business Week, and USA Today. He also has appeared as an accounting commentator on CNN, National Public Radio, and Bloomberg Radio.
I mostly agree with this article. However, I don’t think the stock was necessarily oversold. I think that retail investor expectations were just completely irrational; it seems that the business model and transparency of the company is being questioned just because there was no abnormal first-day return. If retail investors really expected to get rich in one day by exploiting greater fools, they deserve what they got.
The concern about Facebook’s corporate governance is tongue in cheek humor, right?
To my knowledge, the Facebook IPO and its corporate governance structure were designed precisely so that no one has the ability to rein in Mark Zuckerberg. Everything about Facebook’s IPO looks like it was an exercise in Zuckerberg thumbing his nose at the capital markets. But so what? What’s so great about the governance that capital markets provide? Why wouldn’t the owner successful company want to have as little to do with capital markets as possible? Zuckerberg will likely to focus on goals other than maximizing shareholder wealth over the course of a short time span. Is that really such a bad thing?
You are very polite to those who “interpret the plunging stock price as evidence that something is wrong in the accounting”. The reason the stock fell was simply because the stock was overpriced, period.
George Carlin once said about Enron, “If a company can’t explain in one sentence what it does, it’s illegal.” I’m not saying what Facebook does is illegal, but what does it really do? How is it making money? What does it truly sell? Explain that in one sentence and you might find the value of Facebook. I don’t think it can be found, and so I have to agree with John Kleponis, the accounting might be solid, the value is anything but.
I think they facebook was allready at it’s top. It was a great succes but this is where it stops with growing. It will always be like how it’s now in 2012.
Allthough when new things come on the market Facebook may grow, think about Siri (Apple) you can say to you Iphone, send a message to …. and your phone sends a message over Facebook. This is the only thing I know Facebook may do great in the courses.
I work along side a NJ CPA firm and i must say that Facebook’s IPO had to do more with making a few wealthy that worked within the company right off the bat. Facebook’s income is really just the ads it brings into it’s site, but as of right now they cannot keep up with its overall growth. Until Facebook starts pulling out some technological innovations to the marketplace for capital there growth will out way profits by to much of a margin to create a strong stock in my eyes. Facebook would have to change themselves to a pay per profile account scenario and who’s gonna want to invest into that?
Facebook can still turn itself around. They potential is still very good.
Linking mobile social games to mobile phone and computers can create new dominance in multiplayer.games.
Allowing people to shop within Facebook with a facebook checkout system.
Facebook search engine is already tied with bing and can actually be integrated with more engines.
More advertising.
Facebook streaming video channels like netflix.
Its really endless.
Long term stock should be about potential.
Is there a ratio that we could observe that would desribe at what point stock compensation is “too much” relative to sales or some other figure?