Should Facebook Be at $60?

06/07/2012 03:01 pm ET | Updated Aug 07, 2012
  • Alex Frey Author, 'A Beginner's Guide to Investing'

What effect did the NASDAQ's market "glitch" have on the bungled Facebook IPO?

According to the academically popular efficient market hypothesis (EMH) developed by Nobel-prize winning economists, the answer is obvious: none.

But that is probably wrong.

According to the academic theory of markets, traders rationally estimate a company's value and are willing to buy if the share price falls below their estimate and sell if it goes above their estimate. This produces a nice stable equilibrium price that is immune from any glitches. If the majority of market participants think a stock is worth $35 and a market-maker artificially "pushes" it down to $30, demand will kick in from buyers that will bring it back to the $35 level.

The idea that there is greater demand for something at lower prices than at higher prices makes sense for most categories of "things." Take ice cream. If ice cream is selling for $1 a gallon, I'm going to demand a lot of it. If it's selling at $100 a gallon, not so much.

But any trader worth anything will tell you that things don't always work like this for stocks.

Consider a little "thought experiment" about what might have happened to FB if NASDAQ's system hadn't fallen apart in the first hour.

Satisfied that they were entering into a liquid market, traders might have aggressively bought FB immediately after its open in anticipation of a first-day pop (instead of staying away because of uncertainty). That would have sent the stock higher intra-day. Retail investors would have seen this, wanted to get in on the action before it was too late, and bought (instead of selling in the subsequent days out of disappointment, or because they thought they might be reimbursed by NASDAQ by doing so). The stock would have popped and the IPO would have been labelled a success.

Growth mutual fund managers, afraid of hitting quarter-end without a proper allocation to one of the hottest stories in recent years, might have tried to round out their allocations in the coming days by purchasing more shares (instead of dumping their shares to avoid the embarrassment of hitting quarter-end owning one of the biggest failures in years). There wouldn't have been enough shares to satisfy all of them, due to the limited float. The price would have gone up more.

The momentum crowd -- that special breed of fund managers and traders who make a living by buying anything that is going up -- might have seen the price going up, and bought, since that is what they do (instead of seeing the share price go down and short-selling). This might have easily pushed FB up another $5-$10 a share (instead of pushing the price down a similar amount). By the first week of June, the stock would have been trading hands at $60 (instead of $26 today).

Is this scenario really plausible? I don't know. Facebook's IPO came out at a very aggressive (although not entirely unreasonable) valuation amidst a fair amount of media hype. It may have been destined to initially disappoint, as short-term investors who only bought for the expected "pop" sold into a skeptical market.

But if the stock had been priced in its original suggested range, and the first few minutes of trading had gone more smoothly, who knows what might have happened. It is hard not to see scenarios where there is much greater demand for Facebook shares at $50 than at $30, in violation of the economists' models. Which is all the more reason EMH needs to be permanently confined to the dustbin of history.