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Why Facebook bankers nailed the IPO price

(MoneyWatch) COMMENTARY Facebook (FB) shares have now officially dropped below Friday's IPO price. As of Monday morning, the stock was under $34, down by more than 10.5 percent from the initial IPO and more than 24.4 percent off Friday's high of $42 (due to in part to underwriters' intervention to keep the stock from sinking then).

This is far more than can reasonably be attributed to Nasdaq's system problems Friday morning. Some claim that Facebook was overvalued, and that is likely true. And yet, the pricing set by investor bankers was spot on. How can both be right? It's for two reasons: Valuation isn't a logical science and there are strongly competing interests that collide during any IPO.

How low will Facebook's stock go?
Why Facebook's IPO was a success

Value is always a matter of perception. That's why the old toy that someone is willing to let go for a song at a garage sale could command hundreds of dollars from a collector. The toy is only worth hundreds because someone is willing to pay that amount. Apple gets a premium for the iPhone over many Android models because enough people are willing to pay the difference.

The same is true for anything in business, including stocks. During the tech bubble a dozen years ago, people bought stock in companies that had virtually no revenue and, objectively, few prospects for ever gaining some. When the bubble finally burst, everyone walked away rubbing their heads and wondering what happened. The answer is that they all wanted to make money off stocks and collectively drove up the prices in the so-called bigger fool theory: Buy at one price and sell to a bigger fool at a higher one.

Tech stock shares are no different. Many people wanted a piece of Facebook, which increased demand. So the bankers did what they were hired to do: Try to set a price that would meet the demand. Go too high, and people don't buy the stock, which means the IPO is a bust and the company and insiders fail to get the money they could have. Set it too low, as seemed to happen with LinkedIn when the stock doubled on its first day, and, again, the company and insiders lose out.

As my colleague Allan Roth notes, success in IPO pricing means closely matching the offering price to where the stock ends up trading. From that view, Facebook and its early investors did very well and the market said that the price seemed reasonable.

And yet, by other measures you could argue that the company is still overvalued because it trades at 100 times earnings, rather than the 13 times and 18 times that Apple (AAPL) and Google (GOOG) respectively get. Such a difference usually occurs because investors expect that high growth will drive the stock price even higher, which brings us back to the greater fool theory. In short, Facebook's stock was smartly priced because that's what people were willing to spend, even though you might wonder why they thought it was worth that much. But then, you probably aren't buying old toys at yard sales to complete your collection.

Erik Sherman

Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.

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