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Facebook's IPO

Facebook created quite a stir when it recently sold shares to the public for the first time. But despite benefiting from a deluge of hype, the launch disappointed many short-term speculators. Investors, on the other hand, are more interested in the stock's long-term prospects.

But before addressing Facebook's particulars, it is useful to take a brief look at the process. Most companies start off as private concerns and are owned by their founders. So, what motivates them to sell shares to the public? There are several reasons but they boil down to two: the owners want to cash out or they want more money in the firm's bank account for growth, the repayment of debt, or some other purpose. Naturally enough, it is possible to do a bit of both at the same time.

When a stock goes public some of its shares are sold via brokers to their clients. (Typically only very large institutions and the well connected need apply.) The stock then starts trading on a stock exchange where the general public can buy and sell it. The process is known as an initial public offering or IPO.

Most IPOs come with a large side order of risk. As a result, you should ask many questions before buying them. For instance, you should wonder why the shares are being sold to the public by presumably knowledgeable insiders. Perhaps the future for the firm isn't quite so bright? Might the founder be selling at a cyclical high and getting out while the going is good?

Professor Jay Ritter of the University of Florida tracks the performance of U.S. stocks after their initial public offerings and his work is illuminating. It turns out that private owners sell their firms, or parts thereof, to the public at rather fortuitous times.

For instance, Professor Ritter calculates that U.S. IPOs have gained an average of 17.9% on their first day of trading based on data from 1980 to 2011. However, that average was bolstered by unusually strong returns seen during the internet bubble of the late 1990s. Apart from such periods of wild enthusiasm, the initial pop for an IPO tends to be less than 10%.

Low initial price gains are generally the rule because sensible owners don't want to sell at a discount when the market is willing to pay more. On the other hand, big first day surges indicate that they left money on the table.

As it happens Facebook appears to have cleared the table reasonably well. The stock was launched at $38.00 per share, hit a high of $45.00 per share during the first day of trading, and then slumped back to close the day at $38.23 per share. While the lack of a big pop may have disappointed brokers and early buyers, its previous owners extracted their pound of flesh.

However, the average return for IPOs after their first day of trading is generally poor. Professor Ritter calculates that IPOs go on to underperform stocks of a similar size by an average of 3.3 percentage points a year over the next five years based on data from 1970 to 2011. That's a pretty miserable history and it indicates that investors should wait a few years before buying newly listed firms. Indeed, Facebook may be disappointing a littler earlier than usual because its stock slumped 11%, to $34.03 per share, on its second day of trading.

The core problem with IPOs is that they tend to be sold at relatively high valuations when investors are overly enthusiastic about the firm's prospects. True to form, Facebook's stock is quite expensive based on traditional valuation metrics. At the end of the first day of trading, the firm sold at about 29 times 2011's sales and at roughly 110 times earnings.

Both ratios are incredibly high and assume extraordinary growth rates that may not be possible. After all, Facebook has already captured a big slice of its market and it might not attract enough new users to power growth. In addition, it isn't clear that the firm can increase the amount of revenue it generates per user without driving some of them away.

At the end of the day, super high growth rates rarely materialize for large U.S. companies for any length of time. That's a big reason why the 10% of stocks with the highest price-to-sales ratios in the U.S. often disappoint as investments. James O'Shaughnessy determined that such stocks have underperformed the markets by an average of 5.5 percentage points a year from 1964 to 2010 in a study for his book What Works on Wall Street. High price-to-sales ratios are toxic to returns.

The situation is compounded by the decision of Mark Zuckerberg, Facebook's CEO and founder, to maintain control of the company by issuing both single and multiple voting shares. These arrangements are all too common in Canada where they have a lamentable history of allowing founders to divert more than their fair share of a firm's wealth into their own pockets. Although it is not clear that Facebook will follow such a path, such a possibility has to be counted as a risk factor.

To put it succinctly, most value investors wouldn't touch Facebook's stock with a ten foot pole at this point. But a combination of falling prices and improved fundamentals may make it a good deal in a few years.

+ First Published: MoneySense magazine, Summer 2012

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