Why Facebook may fall to $15: Consider the restricted stock

Some investors are hoping for a recovery in Facebook’s stock. Over the course of the last two weeks, it has recovered from its low of $17.55 — and now stands at $22.86.

That’s still 40 percent down from its $38 IPO price.

Could it be that, finally, four months after the disastrous IPO, a little stability is creeping into the stock? Has it found its low, and will it now begin to crawl back upward? In short, is it time to pile back into this stock?

Well, Barrons has just published a piece that argues the stock is worth only $15 and could actually begin to fall.

First, Barrons points out that the stock is trading at a price per earnings (PE) ratio of 48 and a forward price of 36 times 2013 earnings. That’s relatively high, and much higher than the PEs of Apple or Google, which are trading at 16 times 2012 earnings.

Companies can enjoy higher PEs when investors believe they are growing quickly. If earnings are growing faster in the future, why not pay more from those companies now? But Facebook’s problem is that it isn’t exuding the sort of growth potential needed to justify the multiples the market is giving it. Facebook’s earnings statements suggest growth is slowing. Problems in mobile advertising and elsewhere don’t seem to be going away anytime soon.

So far, Barron’s reasoning isn’t entirely groundbreaking. However, Barrons does delve into another area that the market may not have fully digested yet: Facebook has been issuing masses of restricted stock to its engineers, to prevent other hot startups in Silicon Valley from poaching them.

Facebook issued $1.4 billion of restricted stock in 2011, or nearly $500,000 per employee. So far this year, the company has doled out $1 billion of restricted stock. Facebook’s reported stock-based compensation expense—based on the amortization of several years of stock grants—could total 20 cents a share next year. Subtract that from the 2013 consensus earnings number, and the shares trade at 50 times earnings. At $15 they would still be valued at a rich 35 times earnings.

Barron’s points to what it calls CEO Mark Zuckerberg’s cavalier attitude toward issuing restricted stock units (RSUs), which are the stock units that Facebook issues to its employees. It doesn’t have stock options.

Zuckerberg was quoted at the recent Disrupt conference saying: “The way we do compensation is that we translate the amount of cash that we want to give you into shares. So if the shares are undervalued, or valued less than you think they are going to be in the future, you’re going to get more shares for the amount of money we’re willing to compensate you. …”

However, this has a real cost, and it’s something that public investors aren’t likely to overlook for long. In fact, they may be pissed if they begin to think Facebook is trying to do an end-run around them. And this could put further downward pressure on the stock.

Take the argument that investor and entrepreneur (and bombastic owner of the Dallas Mavericks) Mark Cuban made a couple of weeks ago. He said that Facebook pulled off its IPO as well as could be expected. The company priced its stock high, at $38, to maximize its revenue intake, which was an impressive $10 billion. The only people who lost money were the sucker shareholders who believed the hype — or who thought they could pass the stock on to the bigger fool willing to pay more.

Further, Cuban argued that Facebook could ameliorate any morale problems among Facebook employees by simply reissuing stock. By doing so, Facebook would give bigger upside potential to its employees.

(Here’s how RSUs work: Let’s say you were given 1,000 shares when the value of Facebook shares were $30. If the price falls to $10, you have $10,000, instead of $30,000 originally. The stock decline means you have much less value in your shares and that Facebook needs to give you a whole bunch more — this time at $10 — to make you feel as valuable as you were before the decline).

Google was at a similar point in 2009, Cuban points out, having lost more than twice the market cap valuation that Facebook has lost to this point. And Google simply repriced its stock options.

However, Cuban skips over the big difference between Facebook now and Google then. It’s the difference between RSUs, which Facebook has, and stock options, which Google has. “Repricing” of RSUs presumably wouldn’t be applicable in this case, because an owner of RSUs only cares about the current stock price. Instead, Facebook would have to issue more shares at the new price. I’m not an expert on this, and so I’m not sure how directly this would impact public investors.

RSUs apparently also have a taxable value upon issue, while stock options do not.

More importantly, Google had given its public investors five years of extremely solid and steady stock price appreciation before that point. Moreover, in 2009, the significant economic downturn had hit all companies hard. Google’s move wasn’t taken to rectify errors of its own doing. It thus had sufficient political cover for its move. And even then, a lot of investors hated Google’s move. Just imagine the wrath that would be incurred if investors realized Facebook is trying to doing the same thing via RSUs?

It would generate anger that would last for a very long time, and the breach of trust would hurt the stock even more, at least according to some critical, seasoned onlookers of the IPO process I’ve talked with recently. Lise Buyer, the former Google executive who now runs the Class V Group, which advises companies going public, agrees that Facebook can’t reset its employees shares while leaving other shareholders in the cold: “You’ll recall that [the Google] move was preceded by a global economic meltdown that had a big honkin’ impact on the market as a whole,” she said in an email. “This was not an ‘Oops, we sold securities at an incorrect price, and now we are cleaning up our error — at least for our employees.'”

William Hambrecht, another investment banker and IPO expert, said Facebook could possibly try to restore the value of its employees shares, “but it would be opening itself up to all kinds of criticism.”

Ok, so back the $15 stock price. The majority of Wall Street analysts have stock price forecasts that are much more bullish than Barrons’ $15 per share. But then, many of them were way too optimistic before the IPO disaster —  initiating coverage of Facebook with price targets in the $40s. Only one of the almost 40 Wall Street analysts covering Facebook, Dan Salmon of BMO Capital Markets, has a price target of $15, Barrons points out. Most are now in the high $20s or $30s.

Still, with the amount of stock that insiders still have locked up, which will hit the market in coming months, it’s prudent to heed the advice of savvy investor Reid Hoffman, who despite being an early investor in Facebook said he’s waiting for the lock-up periods on insiders’ holdings to end so he can see how the “market responds” to the company.

By then too, we’ll see how the company is playing its RSU hand — with restraint, or liberally doling them out, public investors be damned.