So it looks like Facebook (FB) will finally start trading on May 18th, with the expected valuation greater than $100B. Just to put that number into perspective, Pepsi (PEP) has a market cap of $103B and Kraft Food's (KFT) market cap is $70B. Undoubtedly, FB is one of the most anticipated new issues in recent memory, rivaling Google's (GOOG) IPO in 2004.
We thought the time is right to write about 5 critical but often forgotten facts about IPOs. In the frenzy to make a quick profit, the average investor could get burned trying to get his/her hands on an IPO. This article is not specifically about FB's valuation or chances of doing well but rather is a generic note to any one looking at any IPO investing. Keeping these points in mind could help an investor figure if he/she is really ready to play the IPO game. Let us get into the details.
- The "Initial" Price: Most inexperienced investors assume the opening price on the first day of trading is the initial offering price and they happily buy at that price. The "popping price" is different from the offer price and is usually much higher than the IPO price. Rest assured, if you are an average Joe and your broker calls you to buy an IPO at its offer price, the company is really not worth it. And IPOs that are actually worth it will not be available to the average Joe at the offering price. It will be gobbled up by the big funds and high commission paying individuals long before the opening bell.
- Favorable Circumstances: All IPOs occur when the circumstances are favorable - that is favorable for the sellers (the company and the investment banks). Why is Facebook going public right now after plenty of other social media related IPOs in 2011 like Zynga (ZNGA), and LinkedIn (LNKD)? Why did the Internet bubble have so many ".com" companies going public? Companies go public right at the time they believe the frenzy among the investing public is at a high.
- Survivorship Bias: It is very human to think "oh I wish I bought Apple (AAPL) during its IPO." and "Let me get onto the next IPO and make a fortune". But for every surviving company like Google or Apple, there are equal if not more number of companies went bankrupt soon after their IPOs. Famous examples from the internet bubble include boo.com and theglobe.com
- Lock-up Period: The SEC regulations prohibit insiders from selling their shares to the general public for a period of time, usually 6 months, after the IPO. Once the lock-up period is over, in almost all cases, the insiders dump their shares locking in their profits. And remember these are the same people who were able to purchase the stock at the IPO price. The general advice given to any one holding the stock from its IPO price is to sell it as quickly as possible. This obviously puts pressure on the stock's price over the long term.
- Valuation: A lot, if not most new offerings have valuations that are beyond the norms. Groupon (GRPN) came to the market with such fanfare in spite of not having a profit. And things have turned worse since the IPO and the stock is now trading at less than half its opening price of $28, after popping to $30 soon after the IPO. Again, in a frenzy, investors forget to even look at the basic valuation metrics like earnings and the PE ratio. To quote Wharton Professor Mr. Jeremy Siegel - "Valuations matter, bubble or no bubble".
Conclusion: There you have 5 reasons we believe every investor should be wary of IPOs. Yes, there might be a few skilled or lucky ones who pick great winning stocks but the odds of succeeding investing in an IPOs are not too high for the average investor. This article tracks down the performance of some of the recent IPOs versus the overall market.