The Social Network Effect

Facebook founder and CEO Mark Zuckerberg is going to become an even richer man than he is today. When the company announced on February 1^st that it is planning to hold an initial public offering (IPO), investors estimated the value of the company between $75 and $100 billion. The IPO is expected to raise $5 billion or more, which would make it the largest IPO for an Internet company in American history. There was even speculation that the IPO will create 1,000 millionaires overnight. But for Mr. Zuckerberg, the payday is going to be grand. It is estimated that his wealth could rise to $28.4 billion, making him the age-adjusted richest person in the world. Not bad for a guy who just eight short years ago was eating ramen in his dorm room. This all depends, of course, on Facebook’s share offering being worth $100 billion, which is an awful lot of money for company that lets people stalk their acquaintances.

What is making folks so bullish on Facebook? After all, with an estimated 840 million users (if Facebook were a country, it would have the third largest population in the world), there doesn’t seem to be much room for improvement. One possible explanation is expansion into China (an actual country with the world’s largest population), where the site is ostensibly blocked by the Chinese government. But that seems like an improbable move, despite Mark Zuckerberg’s goal of learning to speak Mandarin.

The other reason to remain optimistic about Facebook’s future value is that it has a firm grasp on its own corner of the social networking empire, due in part to the benefits of the network effect. This phenomenon exists when the benefits of using a product or service increase as the number of other users increases (some would call that a positive externality). A huge benefit of using Facebook, as opposed to a competing social networking site, is that everyone else you know uses Facebook. Just like owning a telephone becomes more valuable as more people own telephones, using Facebook is better when your friends do as well.

And the network benefits don’t end with you as the consumer; it’s also better for the companies who choose to advertise on Facebook. With hundreds of millions of users and a self-furnished list of their tastes and preferences, there is no alternative social networking site that can offer a better target audience for launching ads. It’s these network effects that create a huge barrier to entry for competing social networking sites (like Google+) to challenge Facebook, even if they offer a better service. Why has Google+ not succeeded thus far in threatening Facebook’s social networking dominance? Because everyone and their mother uses Facebook and advertisers can reach a much larger audience.

So while there are reasons to think Facebook isn’t worth $100 billion, the network effect gives the company a firm hold on the industry. And that is something that will make investors “Like” Facebook’s value. 

What Currency Fits Your Wallet the Best?

Last week’s (01/15/2012 to 01/21/2011) major development in the world of currencies revolved around Standard & Poor's downgrade of nine euro-zone nations bond ratings. This week we discuss the performance of the Indian rupee. The Indian rupee is a growth sensitive currency and its performance is dependent on global economic growth and a resolution to Europe’s sovereign debt crisis.

Indian Rupee

The Indian rupee started the week at U.S. $1/INR 51.925 Rs. and made significant gains, closing at U.S. $1/INR 50.969 Rs. On Monday, the Indian rupee reversed early losses to close higher against the U.S. dollar. This was due to large dollar inflows from Indian firms and helped offset the negative sentiment arising from Standard & Poor's downgrade of euro-zone nations’ bond ratings. The Indian rupee appreciated in value after data released showed India's trade deficit in December narrowed to $12.8 billion from November's $13.6 billion. The rupee was at U.S. $1/INR 51.360 Rs. late Monday.

The rupee gained more than 3% against the dollar this year as a result of measures taken by Indian authorities to curb speculation and boost dollar inflows, aside from direct Reserve Bank of India’s (RBI) intervention in the currency markets. Buying back local currency in the international currency market at the expense of U.S. dollars decreases the supply of the respective currency and leads to an increase in its value. However, economists believe that the problems in the euro zone are likely to weigh on the rupee and predict the rupee to depreciate in value to U.S. $1/INR 53.00 Rs. by March. One of their main concerns is that even though India’s trade deficit has narrowed it remains still very high and there will be no support for the rupee unless there is sustained dollar inflow.

On Tuesday, the Indian rupee surged to its highest level against the U.S. dollar in two months, driven by capital inflows and firm local stocks. The dollar was at U.S. $1/INR 50.73 Rs. late Tuesday, after touching an intraday low of INR50.72, a level last seen Nov. 17, 2011. The Bombay Stock Exchange's Sensitive Index climbed 1.7% to 16,466.05. Although the dollar had rose about 19% against the Indian currency in 2011, it lost over 4% against the rupee since the beginning of 2012 as a result of strong inflows into local equity and debt markets.

Foreign investors have pured Rs. 179.65 billion in Indian bonds and equities so far in 2012; compared with Rs. 4.986 billion during the same period in 2011.This has been possible due to the investors’ expectations that the central bank will ease rates to boost growth. This has increased government’s holding of foreign currency reserves, which can be used to intervene in the foreign exchange markets in order to support the rupee.

The Indian rupee appreciated towards the end of the week to a nine-week high against the U.S. dollar, aided by dollar inflows and the news that China would ease monetary policy. Risk-sensitive currencies including the Indian rupee were supported after China's Economic Information newspaper stated that the Chinese authorities planned on cutting banks' reserve requirement ratio by 50 basis points by the end of January. This will lead to an increased liquidity in the financial markets and will have a positive impact on growth sensitive currencies, including the rupee. This helped improve investor sentiment.

So what does the appreciation of the Indian rupee against the greenback imply for U.S. consumers and investors? A weaker U.S. dollar would entail Indian exports becoming more expensive, due to a decrease in the purchasing power of U.S. consumers. On the flip side, a weaker U.S. dollar would increase the purchasing power of Indian consumers and would lead to an increase in demand for U.S. products. This will boost the U.S. exports sector. U.S. investors will have to invest more U.S. dollars in the Indian markets than before.

Verdict: Exchange safe-haven U.S. dollar with Indian rupee. 

Prince and Albert in a Can: The Winner’s Curse

In early December, Albert Pujols signed a ten-year deal with the Los Angeles Angels of Anaheim, worth around $254 million – one of the largest contracts in Major League Baseball (MLB) history. The 31-year-old first baseman is arguably the best hitter in baseball; he has laid claim to multiple MVPs, Gold Gloves and Silver Sluggers, not to mention the Rookie of the Year award. Since 2001 (his rookie season), he has had a batting average over .300 and had more than 100 RBIs in every single season except the most recent (he batted a mere .299 with only 99 RBIs), something that no other player has ever done.

Prince Fielder has thus far had an equally impressive career. He swatted 230 home runs in a little more than six seasons with the Milwaukee Brewers, including 50 long balls in the 2007 season. He has a career on-base percentage of .390 and a slugging percentage of .540, a rare ability to both reach base and hit the ball hard. Though Fielder remains unsigned (as of December 29, 2011) and his trophy case is not quite as full as that of Pujols (Fielder has a pair of Silver Slugger awards), he figures to receive a contract nearly as lucrative.

It hardly seems that either of these ballplayers could be over-valued, but they each have opportunities to deliver a winner’s curse.

The winner’s curse is a tendency for an auction’s winning bid to be greater than the intrinsic value of the item being auctioned. It’s a term from economic theory pertaining to auctions where the value of the item is unknown and the amount of each bid is known only to the one who places it. This condition clearly applies to the market for free agent baseball players; at best, teams can only estimate the value of a player based on his historic performance, and free agent contract negotiations are frequently done in private, such that one team does not know what another is bidding for a player. It is for this reason that teams can suffer from the winner’s curse when signing free agents.

When a player is a free agent, any of the 30 MLB teams can bid for his services. Each team independently evaluates the player’s value and thereby assigns a dollar amount they would be willing to pay for his services. Assuming the player’s production is worth roughly the same to all teams, each team will arrive at an estimate of the player’s value that is close to the player’s intrinsic value. Since teams do not know the player’s intrinsic value (who could predict how many home runs Fielder will hit in the next eight years?) each team’s estimate will be slightly different. On average, the estimates of the player’s value will likely accurately represent his actual value. But the winner of the auction is not the one who places an average bid, it’s the one who places the highest bid – and the one who places the highest bid will have thereby overpaid for the player’s services.

In fact, you sometimes hear players talk about this phenomenon when discussing free agent negotiations or vying for a high draft selection in a new player draft: You don’t need to convince every team that you are an outstanding player who deserves a huge contract; you only need to convince one team. Even if nearly every team accurately assesses the value of a player’s production at $18 million per year, the one team that inaccurately thinks the player is worth $20 million per year will be the one who wins the contract, and will pay too much. Though they likely aren’t aware of it, the players are describing the winner’s curse.

While one could find a long list of players who have been given fat contracts only to underperform, I’ll leave you with one of my favorites. In 2007, the Chicago Cubs signed outfielder Alfonso Soriano to an eight-year contract worth about $136 million. Soriano was coming off a career year in 2006, and had a great first year with the Cubs (batted .299 with 33 home runs). However, his production regressed significantly thereafter; in 2009 he batted just .241 with only 20 home runs and hasn’t improved much since. The Cubs badly overestimated the value of having Soriano on their team, got a bad case of winner’s curse and are consequently paying him much more than his numbers would dictate. The real kicker is that Soriano has a no-trade clause in his contract, which means the Cubs are effectively stuck with him through the 2014 season.

Will Pujols’ and Fielder’s future performance not stack up with their enormous contracts? I suppose that remains to be seen.

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If you made it this far and are still interested, this website has an excellent applet you can tinker with demonstrating how the winner’s curse works. The example is that you are a CFO deciding what to bid on a takeover of a small privately-held company whose value is unknown. It lets you plug in potential values of the company and then submit a bid; it then generates 20 random scenarios and tells you if your bid won and how much your profit/loss is.