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:

Low-float Technology sector IPOs, 1998-2007

1-day

Subsequent lifetime*

Median outperformance (underperformance) relative to the Nasdaq Composite Index +10.0% (5.0%)**
% of IPOs beating the Nasdaq Composite Index

83%

10 of 12

33%

4 of 12

*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:

Median outperformance (underperformance) relative to the Nasdaq Composite Index

1-day

Subsequent lifetime*

GroupOn

+29.8%

(26.7%)

LinkedIn

+108.0%

(-23.1%)

Pandora Media

+10.0%

(31.2%)

Zillow

+78.0%

(17.5%)

*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.)

Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of LinkedIn. Motley Fool newsletter services have recommended buying shares of Zillow. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (8) | Recommend This Article (22)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 06, 2012, at 11:45 AM, sikiliza wrote:

    I simply do not invest in companies whose businesses I do not understand and cannot predict with any degree of reliability.

    For one, FB seems to have quite a bit of cash on its BS and hence the IPO is an opportunity for early investors to cash out.

    Second, their only competitive advantage is that they got there early and got big. We've seen that dynamic change countless times on the hi-tech space.

    Lastly, when you invest in the stock of a company, you implicitly own a little slice of the business, which allows you to vote on issues of importance to you - why would I want to buy non-voting shares as an Investor?

  • Report this Comment On February 06, 2012, at 12:19 PM, terracomm wrote:

    just one point.

    coin tosses are independent events.

    in other words, the odds of returning either heads or tails is ALWAYS 50%.

    there is so cumulative odds at work.

    otherwise, loved the article.

  • Report this Comment On February 06, 2012, at 12:35 PM, TMFTomGardner wrote:

    I love the research behind this. I definitely think investors looking to buy Facebook should not do so in the early days. One question, though, Alex -- Don't you think an offering this size HAD to feature a low percentage float? The dollar float is huge at $5 billion. I think the best long-term study would look at the returns from popular IPOs that raised more than $1B.

    In the end, I'm not sure this fits neatly into the label of "small float offering."

  • Report this Comment On February 06, 2012, at 12:37 PM, JBG189 wrote:

    in other words, the odds of returning either heads or tails is ALWAYS 50%.

    Did the author say it was anything other than that?

  • Report this Comment On February 06, 2012, at 2:35 PM, gnumantsc wrote:

    I think it will obviously spike but I think people are treating this stock as the next Google.

    The #1 issue that is keeping FB from owning more money is the fact that about 40% of people use the mobile platform which does not display ads at all so they are not making money at this time.

    I still think they are a few years too late and having Zynga as one of the top money makers for you isn't a great idea. There needs to be expansion besides gaming.

  • Report this Comment On February 06, 2012, at 2:37 PM, TMFAleph1 wrote:

    @terracom

    Nothing I wrote violates the independence of coin tosses or the assumption of equal probability of heads or tails. I'm not sure what you were getting at.

    Perhaps if you explain your point in different terms, I'll get it.

  • Report this Comment On February 06, 2012, at 2:44 PM, TMFAleph1 wrote:

    @TomG

    You raise a good point. At $5 billion, Facebook would rank 12th on the list of largest US IPOs.

    We'll have to wait and see, but my guess is that, despite the size, investors will absorb that paper like nothing and the issue will be heavily oversubscribed.

  • Report this Comment On February 06, 2012, at 3:34 PM, CromulentBrad wrote:

    here's the question i have: how is this company going to continue to grow?

    google moved beyond just being a web browser. apple moved waaaaay beyond just producing pretty desktop computers. disney bought espn. even mcdonalds added breakfast to the menu.

    unless facebook can evolve into something more than a really big scrapbook with questionable privacy issues, i won't be buying it.

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