Yesterday, I came across an interesting blog post by Aswath Damodaran regarding the valuation of Facebook. For those who don't know who Aswath Damodaran is, he's a Professor of Finance at the Stern School of Business at NYU who also teaches MBA classes, and he's also the author of several reference books on valuation and corporate finance. Indeed, for anyone wanting to learn more on those subjects, it would be useful both to buy his books and to visit his website where much can be learned for free.
But back to his blog post, after explaining is assumptions and adjustments, he comes to a value per share of $29.05, which would give an IPO price of around $28. He also estimates a wide range of possible future values for Facebook, allowing even for a market cap of $120 billion. Then, he concludes:
Would I buy Facebook stock, if its equity were valued at $75 billion? No, and not because I believe that the price is outlandish, but for two other reasons.
- The first is that the price reflects the expectation that Facebook will become a phenomenal success. Anything less than superlative will be viewed as a failure.
- The second is that what Facebook is brazen about the fact that they don't see any need for input from stockholders. In effect, they want my money but don't want me to have any say in how the company is run. This does not jell with the notion that stockholders are part owners of the companies that they owned stock in. You may be comfortable with Zuckerberg as CEO for life but I am not. I am sure that I am in the minority on this one, but different strokes for different folks....
And this is what brings us to this article. $75 billion is a given for the IPO price, indeed, the IPO price will probably imply a valuation of $100 billion. So what Damodaran is saying is the same as "If I were given a chance to buy Facebook at the IPO price, would I buy?", and replying "no".
And that's where we have an issue. Anyone able to buy at the IPO price would be doing a mistake NOT to buy.
A widely studied subject
There is a large body of research on a phenomenon called "IPO underpricing". I am not going to say that IPOs come to the market below their intrinsic value - they don't -but IPOs do consistently come to the market at a price that is exceeded with a large dose of certainty and by a large margin, on their first day of trading - and that is what's called "IPO underpricing" in the academic circles.
These are just a few studies on the subject, in no particular order and not meant to be a complete list (that would be enough work for a doctoral thesis):
- "IPO Underpricing", Peter L. Karlis
- "The IPO Effect and Measurement of Risk", John D. Knopf and John L. Teall
- "IPO Pricing Phenomena: Empirical Evidence Of Behavioral Biases", Michael Adams, Barry Thornton and George Hall
The gist of these studies is always the same - there are very large excess returns to be had for anyone that can consistently buy IPOs at their offering level. This is something that certainly, most have already empirically observed. On the "IPO Pricing Phenomena: Empirical Evidence Of Behavioral Biases" we get a quantification of this effect for several past years:
click to enlarge
1st day returns ranging, over the years, from 9% to as high as 72%. And these are measured against the close; during the trading day it's usual to have even higher returns available.
So, any rational investor that had access to future IPOs at their offering price would be hard pressed not to buy every IPO he could get his hands on, mostly regardless of valuation.
Pandora (P) IPO'd at $16 and closed the first day at $17.42 for a gain of 8.9%. The stock traded as high as $26, showing that even the first day close sometimes greatly understates how much return is available on the first day for whoever buys at the IPO price.
Zynga (ZNGA), IPO'd at $10 and closed the first day at $9.50 for a rare loss of 5%. Still, those buying at the IPO price had a chance to get out with gains, as the stock traded as high as $11.50 on the first day.
Linkedin (LNKD), IPO'd at $45 and closed the first day at $94.25 for a gain of 109.4% in a single day, showcasing how massive the gains can be for those that can buy at the IPO price. And the stock traded as high as $122.70.
Zillow (Z), IPO'd at $20 and closed the first day at $35.77 for a gain of 78.9%. The share traded as high as $60, where it would have a gain for a IPO subscriber of 200% …
Groupon (GRPN) IPO'd at $20 and closed the first day at $26.11 for a gain of 30.6%.
Damodaran's conclusion that he wouldn't buy the Facebook IPO if offered shares at a $75 billion valuation is not rational. At the very least, anyone having the chance to get Facebook IPO shares at the offering price should take that chance and buy, even if only for a few hours, until they can "flip" (sell back the shares to the market on the first trading day) the shares.
Granted, Damoraran can be talking about not buying Facebook at a $75 billion market cap for the long term. I wouldn't disagree with such a conclusion - the thing here is that buying at the $75 billion, or even $100 billion, valuation as long as such valuation is relative to the IPO price, has little chance of not being a very good deal, once one decides to sell into the very obvious pattern regarding the first day of trading in the secondary market.
As much as there's a bias towards underpricing IPOs (using their first day close as a measure of the underpricing), there's a bias towards overpricing them if we consider their longer term performance. This might be the subject of a future article.
Also related to this theme, readers might be interested in my article "Dissecting Lock-Up Date Expirations".
A lot of interesting data on IPOs can be gotten at Professor Jay Ritter's webpage.