The frenzy around IPOs doesn't necessarily mean they're a good investment.
Much ado has been made about the Facebook initial public offering (IPO) that was announced in early February, with investors lining up for stock in an already legendary company. However, does that make investing in the Facebook IPO a good deal?
The company set off a frenzy when it filed to raise as much as $10-billion (U.S.) in cash through the IPO, which would give it a market capitalization of around $100-billion. This could place Facebook as the fourth-largest IPO ever in the U.S., behind companies like Visa, General Motors and AT&T Wireless.
What do the numbers mean? Well, since the company is selling only a small percentage of its shares, its current management team, led by co-founder and CEO Mark Zuckerberg, will retain almost complete control over the company. This means new investors will have virtually no say over how the company is managed. In addition, Facebook's valuation is based on rapid growth. In 2010, the company had profit of $668-million on revenue of about $3.7-billion. With a valuation of $100-billion, Facebook would have a trailing price-to-earnings ratio (the current market value of a company divided by its most recent historical earnings) of around 149.70. To put that in perspective, in July of 2011, Microsoft reported 2011 income of $23.15-billion. With an equivalent multiple, Microsoft would be worth nearly $3.5-trillion.
Analyzing other IPOs
Can it pan out? Well, in instances past, it has. Those fortunate enough to invest in the Microsoft IPO ($21 per share in March, 1986) and held onto their shares through Feb. 23, 2012, the last trading Friday of the month, would have enjoyed a 43,000-per-cent return. That means every 100 shares bought then for a total of $2,100 plus trading fees, and held through that date would have grown to 28,800 shares worth over $900,000 (Based on a Feb. 23 closing price of $31.48, Microsoft's stock has split nine stock times since its IPO).
On the other hand, investors in AT&T Wireless were not so fortunate. The company priced its stock at $29.50 a share in April of 2000, and by October, 2002, its price had drifted all the way down to $4.19. Two years later, after a series of missteps, the company was acquired by Cingular Wireless for about $15 a share.
So why the frenzy when it comes to IPOs? Those in academia, who have studied investor behaviour, say that, while on average, IPOs have actually been underpriced, the median IPO based on comparative peer evaluations has been overpriced and that "results suggest IPO investors are deceived by optimistic growth forecasts and pay insufficient attention to profitability in valuing IPOs." In layman's terms, this means that investors' judgment can get clouded when analyzing a potential IPO investment. Fear and greed , which originate from two of our most primal instincts – fight or flight – are the culprits.
When we're in "fight" mode, we tend to concentrate on the glory and spoils of victory, such as nice homes or nicer cars. Conversely, when we're in "flight" mode, our focus turns to avoiding the dire consequences of loss and defeat, as we aim for survival and self-preservation. It's that desire for wealth and recognition or the fear of being poor and excluded, that often drives investors to chase after IPOs without doing their research.
Usually, neither extreme comes to pass. When a company goes public, much of the profit already has been made because the owners/original investors are harvesting their gains. Long-term IPO investors can still make money by investing in profitable companies at the right price. However, for most investors, getting in on an IPO is not likely. Brokers are allotted a certain number of shares, and they typically reserve those shares for investors who meet certain criteria (usually relating to the size of their investment account), so most will have to invest in Facebook "post-IPO."
The bottom line
So, here's the "skinny" on the Facebook IPO frenzy. The typical investor probably will not get in on it. After the IPO, those with investable dollars can buy the company's shares, which may be a good bet for those in it for the long haul. When it comes to IPOs in general, look for viable, long-term business models and profitability. Do not let emotions take over. Instead, make a rational investment decision and invest for the long haul. That kind of strategy builds wealth over time and allows you to sleep well at night.