Why We Didn't Invest In Facebook's IPO

| About: Facebook (FB)

It has been three weeks since the most anticipated IPO was introduced to the investing public. In that time, the dust still has not settled from the surprising outcome. Facebook's initial public offering (IPO) was not the resounding success most people thought it was going to be - at least for those outside the company. Several factors contributed to this unexpected result, and validated our reasons for not participating in Facebook's IPO.

Most people who researched the company and read its Form S-1 filing (the public document companies file in advance of an initial public offering) should have discerned that one of the primary reasons Facebook (NASDAQ:FB) filed for an IPO was to provide a return to their angel and venture capital investors. The average timeframe for a return on investment in Silicon Valley is three to four years. It has been eight years since The Facebook was launched. Facebook's investors have been more than patient.

As a result, it goes to reason that they would expect a return similar to having invested in a startup for four years and then reinvesting the proceeds into another startup for another four years. This eventually led to heightened expectations for the IPO.

In going public, most companies raise money to reinvest back into the business to take it to the next level. Facebook, however, already had close to $4 billion in cash prior to going public, and didn't necessarily need an IPO to raise capital. They knew that there were still plenty of venture capital investors willing to invest in Facebook as a startup.

Knowing that one of the primary drivers of the IPO was to provide a return to its investors, and the fact that this has been one of the most anticipated IPOs in recent memory, Facebook's underwriters (Morgan Stanley as lead underwriter) swung for the fences. Not only did they price the shares on the high end of the range in the week leading up to the big day, but also increased the number of shares to be sold to the public. The result was an overpricing of the shares that led to a drop in the share price from the outset. What didn't help matters either was that Nasdaq, the exchange that Facebook registered under, could not keep up with the volume of trade orders.

Putting aside all these factors, there are more practical reasons why we didn't participate in Facebook's IPO. One is that investors will almost always pay a premium when they purchase a company's stock at its initial public offering. The hype and hysteria generated by an event like an IPO only bids up the price, and the frenzy surrounding Facebook is well documented.

Second, the underwriters set Facebook's valuation like it was the late 1990s all over again at the height of the tech bubble. With an initial stock price of $38 per share, and diluted earnings of $0.46 per share, Facebook's price to earnings ratio (PE) of 83 is not for the faint of heart. As a result, investors who bought shares after the IPO certainly did not party like it's 1999. On the other hand, one of the distinctions that set Facebook apart from the IPOs of the late 90s is that it was at least a profitable company when it went public.

I do not doubt that Facebook will continue to grow its earnings and eventually find a way to monetize (make money) advertising on its mobile app. But make no mistake that Facebook is first and foremost a social media company whose mission is to connect people. Making a profit is a secondary objective. Facebook's CEO, Mark Zuckerberg, states: "Simply put, we don't build services to make money; we make money to build better services."

One of the companies Facebook is often compared to is Google (NASDAQ:GOOG). There are many reasons for comparing the two. Other than the fact that there was exceptional hype in advance of their IPOs, they are also fierce competitors for engineering talent. Even though both companies derive most of their revenues from advertising, search is a proven money-making machine, and the profit margin Google derives from its search business is one of the highest of any technology company. Whereas, Facebook's advertising business model is still in its infancy. The profit margin it generates is only typical of tech companies, and the profit making potential of its social graph is still to be proven.

Facebook is not the only tech company that has gone public in the last year. As a prelude to Facebook's IPO, Zynga (NASDAQ:ZNGA), the developer of online games such as Farmville; Groupon (NASDAQ:GRPN), the online discount site; and LinkedIn (NYSE:LNKD), the professional social media site; have all gone public to take advantage of the hype surrounding Facebook going public. Yet, only LinkedIn's shares are currently trading above its IPO price. In other words, the common perception that shares of IPOs rise upon going public is not always true.

This is where the value of an advisor is worth its weight in gold. It takes old fashioned research of reading S-1s and other information to determine if a company is a worthy investment candidate. In addition, being disciplined with an investment philosophy deters one from being influenced by the hype generated by the media in trumping the latest tech startup going public as if going public is a recipe for success for investors.

To better understand what type of company makes for a good IPO investment, we should look at the one IPO we did participate in at CAP Partners, and that was Visa (NYSE:V) in March 2008. Visa was a rare IPO in that it was not a new company when it went public. At that point it was already in business for over 30 years. As a result, its business model had been proven many times over.

Even though Visa's valuation (PE) was high when it went public, which is typical and reflects the premium an investor pays for buying at the IPO, the valuation does go down over time as the company's earnings grow. When Visa went public at $44 per share, its earnings was $0.96 per share, which translated to a PE of 46. Today, Visa's shares trade at $116, and earnings in the last year was $4.28 per share, which makes it's current PE at 27. In a little over four years, investors have seen a 163% return simply on price appreciation, which does not include dividends.

The moral of the story of Facebook's IPO is that a great company, such as Facebook, does not necessarily translate into a good investment at the IPO. So the next time you hear of an exciting tech startup that is about to go public, remember that not all IPOs go up immediately after going public, and that there are more Facebook and Zyngas than there are Visas.

Disclosure: I am long V.