Investors will undoubtedly be clamoring for shares of Facebook (FB) when its IPO hits the market in May. But since we still have a few weeks to wait, let's take a moment to look at the tech IPOs of the past 2 years in order to get a realistic view of possible performance.
Most IPOs, especially tech IPOs, do not have a stable earnings stream, and their incredible growth stories are sold to the unsuspecting public.
The surest way to see if the IPO might be a dud is to find out how the initial investors will do with their new riches. Many tech firms are funded by venture capitalists, and you better believe that VCs will hold on to their share of the company if it actually believes that the company is worth more than what the general market is paying for it.
This does happen sometimes, but most of the times it does not. IPOs go through the roof on the first day, and then everyone bails out. It is just the nature of the business - which is why some people are arguing that social media companies are the new tech bubble.
Everyone likes fads
An all-out IPO strategy for an investor is rarely a wise wealth building strategy. Ironically, many investors seem to know this, but it all seems to get forgotten. LIke the new fluorescent-colored athletic shoes, everyone seems to like a new fad. And everyone loves a fast-moving stock.
I looked through a few previous tech IPOs and their performances. The results were surprising to even to me. The IPOs did even more poorly than I anticipated. Only 4 of the 10 IPOs have yielded absolute positive returns since their debut. A full 9 out of 10 of them have underperformed the Nasdaq with only Zynga (ZNGA) - and Zynga is still highly dependent on Facebook - outperforming by a tiny 0.3%, as shown below.
We can also see that the IPO performance is loosely impacted by the price level, which I have shown as a Price to Sales/Revenues ratio in the year of the IPO. (The purpose of using P/S is simply because most of these companies did not generate any earnings in the year of they had an IPO, which renders P/E meaningless.) It is also important to note that the performance of the S&P and the Nasdaq were positive during all the different periods that we calculated, which shows that the general market investor sentiment was not negative, which could have affected the perception towards risky tech IPOs.
We do not see a pure relationship between valuation (P/S) and post-IPO returns, but we can see that companies like HomeAway (AWAY), Renren (RENN) and Pandora (P) Media with extremely high valuations have performed terribly with losses of 59%, 79%, and 73%, respectively, since their initial IPOs. Groupon (GRPN) did a bit better, but the problems with Groupon's business strategy are well-known.
The best performer has been Zynga, with a relatively low valuation of P/S of 2.2. Facebook is expected to be valued around $100 bn at its IPO, (although Facebook may not be worth as much as some people think.) Given that Facebook's revenues were $3.7 bn in 2011, this would value the company at around a P/S of 27 and P/E of 100, pretty expensive, and on the upper scale of the companies noted above.
But like LinkedIn (LNKD) - and LinkedIn may already may be too expensive - Facebook might be able to maintain its extremely high valuation as long as it can grow its user base simply because of the Network Effect, which means that the value of a product, like a network or community, increases with the number of users. This will at least maintain the high valuations, at least for a while.
So a final word on tech IPOs, they tend to very expensive and unproven business models. Facebook has a more solid business model, as it generated solid growing earnings of $1 bn in 2011. Question is, is its potential growth worth the $100 bn sticker price? Probably not, and even though most people will know this, many will depend on the greater fool theory to make money, as long as they are not the greatest fool.