With the meteoric rise of LinkedIn's stock price following the initial public offering, or IPO, on Thursday, talk has turned to short selling the social media network's shares.
The price of the stock is forecasted to decline on Tuesday after trading constraints are lifted, the Financial Times story "Short sellers set to target LinkedIn" reported on Monday. The price fell from $94.25 at the market's close on Thursday to the mid-$80s on Monday.
From the story:
… complicating the picture for short sellers of LinkedIn is the small size of its float: just 9m shares, as the group sold only 10 per cent of its stock in the initial public offering.
"There's no way you can find a borrow, there was such a limited amount of stock sold. It would be prohibitively costly to put on a short," said Doug Martin, a trader at Kitano Capital, a private investment firm.
LinkedIn's shares were initially valued at $45 but last Thursday, the day of the IPO, they more than doubled in price.
Why was there a huge disparity between the original valuation and the actual price?
Henry Blodget at BusinessInsider.com speculated that the stock may have been purposely undervalued by the underwriting bank to line the pockets of institutional investors.
In the story "Congratulations, LinkedIn! You just got screwed out of $130 million," Blodget offers this analogy for underpricing IPOs.
Imagine if the trusted real-estate agent you hired to sell your house persuaded you to sell it to her best client for $1,000,000 by telling you this was the best price she could get. And then, the next morning, the person who bought your house immediately turned around and sold it for $2,000,000 (using the agent to sell it, naturally).
On Reuters, finance blogger Felix Salmon weighed in on the controversy, in "The LinkedIn IPO debate" and concluded that the underwriters had valued the company as fairly as possible, but it's the IPO system that is flawed.
The bankers don't only want to place stock with high-quality long-term investors; they also want to achieve one of the main purposes of going public in the first place, which is price discovery. For that, you need a substantial volume of buyers -- and sellers -- all day every day for years and decades to come.
In other words, it's the market which sets the price of the stock; it’s the job of the bankers to bring the company to market.
And that brings us back to short selling.
When investors short a stock, they're betting it will fall in price. In order to short sell, an investor must borrow shares of the stock from another investor or brokerage. The borrowed shares are sold at the higher price and then bought again for a cheaper price.
Amid all the debates over the real value of the social media network, investors looking for a long-term investment will be at the mercy of those looking to benefit from short-term volatility.