The initial public offering (IPO) of the international e-commerce company Alibaba recently attracted a lot of attention -- not to mention a couple billion dollars of investment money. This might be OK if it were an isolated occurrence, but lately there has been a flurry of IPOs -- and they make me feel a little itchy about the investment environment.
I understand the principle that growing companies opening themselves up to new sources of capital is one way the economy grows. However, when investors go overboard for IPOs -- either by overpaying for specific stocks or supporting too many new issues at once -- it raises questions about both individual stocks and the market as a whole.
What kind of questions? Well, here are nine things that IPOs make me wonder:
- Is it just a status buy? The clamor to get in on IPOs reminds me of the lines of people outside a store waiting to buy some fad toy. You have to wonder how many of these people are making independent assessments of value, as opposed to just trying to capture the status of being one of the first to own a much-hyped introduction -- in effect, people who are just lining up because everyone else is lining up. I don't see much utility in going to great lengths to own something a little earlier than everyone else, and I also know that kind of hype can obscure the questionable worth of these fads. After all, do Cabbage Patch dolls really seem worth all the fuss in retrospect? Or, to ask about a more recent example, how's that Groupon stock doing?
- Raising cash or cashing out? Publicly, companies issuing stock talk about raising capital so they can continue to invest in the business plan. Privately, the owners of those companies talk about creating liquidity -- a smooth way of saying they are giving themselves a means of cashing out while the company is still worth something. Trying to figure out whether a management group is really raising cash or cashing out leads me to ask this next question.
- Raising cash for what? Given the magnitude of the capital being raised, there should be some pretty extensive expansion/upgrading plan for how to use that money to grow the company. If you don't see a plan commensurate with the amount of money being raised by an IPO, you have a right to question the motives of management.
- Can entrepreneurs and public shareholders get along? Entrepreneurs are often stubborn, long-term thinkers who would rather pour profits into the next idea than simply bank the profits from their successes. That's why some of them make a huge difference to the economy and society -- and also why many others eventually fail. Once a company goes public, there is a natural friction between this kind of risk-taking, long-range thinking and the demand of shareholders for positive quarterly results.
- What's the incentive now? The classic start-up fantasy is that a small group of young, hungry entrepreneurs working out of a garage somewhere goes on to become instant billionaires on the day of their IPO. The question is, once they have achieved that fantasy, how many of them can stay hungry about their work?
- Is the earnings multiple justified? You may love a company's products and the way it does business, but that does not mean it's worth the price once the stock gets driven up by IPO hype. Alibaba, for example, was recently selling for just over 40 times its annual earnings. That means it would take you 40 years to earn back each dollar you invest, unless the company's earnings grow into that price level -- which leads me to another question....
- How does this impact the earnings growth rate? An essential part of IPO hype is the growth story -- imagining what the company will become if it can simply continue its impressive rate of growth to date. The problem is, given the scale necessary to be considered ready for an IPO, and the investment implicit in raising that much capital, continuing that growth rate for years and years becomes problematical. Mature companies simply don't have the opportunity to match the growth rate of new start-ups.
- Will there be a better buying opportunity in the near future? If you still like the company, consider whether there might be a better buying opportunity after the initial hype has died down -- either when the stock experiences a post-offering slump or during the next broad market downturn.
- Has indiscriminate investing taken over? This is the bigger-picture question, about the state of the market as a whole when IPOs start to pop like popcorn. In that environment, are people still thinking of companies as an earnings mechanism designed to pay a return to shareholders, or are they just buying stocks like lottery tickets?
None of this is meant to imply that you should not invest in IPOs, but you should ask yourself some tough questions before you do.
This article originally appeared on fivecentnickel.com.
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