Facebook's IPO: Where's the 'Dislike' button?

Facebook filed for an initial public offering (IPO) on Wednesday, ending the speculation concerning the most anticipated flotation since rival Google went public in 2004. The investment bankers will make out like bandits, sharing $50 million to $100 million or more in fees (Morgan Stanley will lead the deal). Investors, on the other hand, shouldn't expect a big payoff; in fact, they'd be wise to steer clear of a stock that will almost certainly end up overpriced once it begins trading.

Why am I convinced the flotation will produce inflated prices once the shares are freely traded? Because floating a small stake in a high-profile company to hyped-up investors is an ideal combination to facilitate a mispricing of the stock by creating an imbalance between supply and demand. This isn't just a theory of mine.

An IPO gone wrong
The most spectacular example of this phenomenon occurred in 1999, at the height of the Internet bubble. 3Com was spinning off its Palm subsidiary (the handheld device manufacturer) in a two-stage process. In stage one, 3Com would offer 4% of Palm shares in an IPO; in stage two, the parent would distribute to its shareholders 1.5 Palm shares for every 3Com share they owned. The right attached to 3Com shares therefore established a theoretical floor on their price equal to one-and-a-half times Palm's stock price.

Despite this, at the end of Palm's first day of trading, the shares closed at $95 against $82 for 3Com's, for an implied value of 3Com's non-Palm assets of negative $63! This was all the more bizarre given that 3Com had $10 per share of net cash on its balance sheet. Was this a lone example, the product of exceptional circumstances? I don't think so. However, mispricings are rarely as easy to detect as that one.

The data doesn't lie
One way to identify anomalous valuations with the benefit of hindsight is to examine the returns subsequently achieved. Market-beating returns point to an initial undervaluation; conversely, market-trailing returns suggest an overvaluation -- particularly if they occur systematically. I gathered data on all Technology sector IPOs since June 1996 with the following characteristics:

• The number of shares offered was less than 20% of the company's shares outstanding.
• An implied market capitalization based on the offering price greater than $2 billion based on the offering price. Since we're looking for high-profile IPOs, I wanted to exclude small-cap stocks. I could have set the floor higher, of course, but the sample would then become very small.
• A minimum of three years in the public markets. To quote Benjamin Graham, "In the short run, the market is a voting machine; in the long run, it's a weighing machine." The longer the period, the more information observed returns convey in regard to a stock's initial valuation. The average public market tenure in my sample is 7.5 years.

I then calculated two sets of returns for the twelve companies in my sample: The first is the 1-day return based on the IPO offer price and the closing price on the day following the offer; the second is the return-to-date between the day following the offer and the end of last month. I compared each of these to the corresponding return of the Nasdaq Composite Index. The following table summarizes the results:

*To January 31, 2012. **Annualized. Source: Author's calculations based on data from S&P Capital IQ. Source: Author’s calculations based on data from S&P Capital IQ. ^†Price return, based on the IPO offering price. ^††Annualized.  *To January 31, 2012.

The evidence of short-term outperformance coupled with long-term underperformance suggests that the IPO process produced (or amplified) an overpricing of the shares immediately after the transaction was consummated. Consider, for example, that the odds of at least ten of the twelve offerings beating the index over a one-day timeframe purely due to chance are the same as that of obtaining heads 10 or more times in 12 coin tosses -- less than 2%.

The "Facebook effect"
Even Facebook's first president, Sean Parker, acknowledged that the supply-and-demand dynamics have the potential to skew valuations. At last week's World Economic Forum in Davos, he told CNBC, "To the extent that there is any bubble in technology at all, it is really a bubble around Facebook in the sense that there is a huge amount of pent-up demand among retail investors for access to Facebook equity."

Is there a bubble around Facebook? It's difficult to say with any certainty because existing social-networking stocks have such a short price history. One thing is certain: GroupOn (Nasdaq: GRPN), LinkedIn (NSYE: LNKD), Pandora Media (NYSE: P) and Zillow (Nasdaq: Z) all displayed the same pattern of massive first-day outperformance, followed by a brutal correction:

*These returns are not annualized, as the period is less than one year. Source: Author's calculations based on data from Renaissance Capital and Yahoo! Finance.

Has the correction produced prices that are now attractive? Not to my mind: All continue to look very expensively priced. Furthermore, only LinkedIn and Zillow display any sort of competitive advantage. Even Pandora, which offers a good user experience, looks increasingly vulnerable to Spotify. In fact, I have no hesitation in adding all four stocks to my CAPS tracking account with an "underperform" rating.

Facebook's IPO is no friend to investors
In June, I wrote that I expected Facebook to end its first day of trading with a market value in excess of $150 billion, and I feel even more confident of that forecast today. Even at a $100 billion market value -- 100 times 2011 earnings -- investors will be hard-pressed to earn a decent return on the stock. There's not much to like about that (at the opposite end of the hype spectrum from Facebook, one tech company has flown under investors' radar, but it's The Only Stock You Need To Profit From the NEW Technology Revolution.)