IPO: It's Possibly Overpriced?
Palwasha is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Sage of Omaha warns investors of IPOs. Putting it in Buffett’s words;
"It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less-knowledgeable buyer."
Makes little sense? Read on!
Buffett’s mantra is to not buy shares directly off IPOs, rather buy them once they’ve stabilized to their fair or below fair values. So, by Buffett’s definition, IPOs are overpriced. And interestingly enough, studies have shown the same. But if all investors believe Buffett’s words to be true and nobody shows up to buy at an IPO, the whole idea of an IPO becomes counter intuitive. Plus, by definition, IPOs are to be underpriced, or at least fairly priced, to induce investors to buy. If all IPOs were overpriced, stock exchanges would have been non-existent today.
Let’s consider an example to understand this further.
Take for instance the recent IPO of a social media giant that made headlines for months. Do I have to name it? No? Duh! Everybody was suddenly interested in IPOs. My brother, who is an undergrad with a non-finance background, also confessed that he Googled ‘IPO’ to figure out what it was because almost everybody he knew was talking about it.
Coming back to IPOs being overpriced; Zuckerberg, founder of Facebook (NASDAQ: FB), lost $2.1 million in less than a week after Facebook’s IPO when the overpriced (read: overhyped) stock fell more than 18% below its IPO price.
So why do IPOs get overpriced in the first place? While the investment banks are routinely blamed, the simple answer to this question can be found yet again in Buffett’s words:
“People get excited about companies that have done that well.”
In other words, the culprit is "investor sentiments."
Investment banks in an underwriting arrangement try to get the best price for the issue being underwritten. The price is set by simple demand-supply rule -- the more positive the investor sentiments, the higher their demand and the higher the price. This is simply why Facebook IPO was a ‘hot issue’ even before it was issued. It was the talk of the town and everybody wanted a piece of it.
This idea leads to yet another question. What causes investors to hold an overly positive outlook for a company when it actually doesn’t have one? In our example, while competitive advantage and industry positioning may have made investors overly excited about the company, most investors failed to factor in Facebook’s asset base.
In order to determine the fair value of a company, investors need to value its assets. In our example of Facebook, the company’s principal revenue generating assets are its user base (revenue is quoted as RPU, revenue per user). It is Facebook’s user base, an intangible asset, that generates revenues for the company in exchange for services that generally create no value in economic terms. And we all know that intangible assets cannot be objectively valued with 100% certainty. Hence, their greater chance of ending up being overpriced. This is exactly what happened with this overhyped IPO.
Contrast this with other recent IPOs that didn’t get the limelight that Facebook did.
- Tesaro Inc. (NASDAQ: TSRO) is a biopharmaceutical firm that makes therapeutics and other supportive products for cancer patients. Tesaro’s IPO, which took place in the last week of June, was priced at $13.50/share. It’s been only a week or so and the stock has jumped 2.5%. The company intends to use the IPO proceeds amounting to approx. $81 million in the development of cancer drugs. Now that’s a tangible product in the making!
- EQT Midstream Partners, LP (NYSE: EQM) is another company that offered its shares for the first time in the last week of June. EQT’s shares are up 15% within a week, from their IPO price of $21/share. EQT Midstream Partners is a subsidiary of EQT Corp. and transmits and stores natural gas locally in Pennsylvania and West Virginia. The company serves through miles of interstate pipeline system—another tangible asset base.
- ServiceNow, Inc. (NYSE: NOW) is the third company that got IPO-ed in the same week as the previous two companies and has seen the biggest price surge since. Its shares are up by 41% in a week’s time from its IPO price of $18. The company deals in the service sector, has been in business for nine years and provides automation of enterprise IT operations to companies in order to help them decrease their costs. Again, the company’s operations lead to tangible value generation.
If I were to put this in simpler words, it would be something like this;
My analysis doesn't compare these companies on the basis of their future prospects, rather identifies the companies that got listed above their fair values. While Facebook may have better growth prospects than all of the above mentioned companies, the Facebook IPO was clearly overpriced. I base this conclusion on the premise that investors’ sentiment in the form of excess demand played a strong part in overpricing the Facebook IPO (and it has been trading below its IPO price ever since). Calculations of intrinsic value were also vague due to intangibility of its principal assets. Both of these factors were absent in case of the three companies mentioned above. Thus, we can safely assume that their IPO prices were under or fairly priced (all three of the companies have been trading above their IPO prices ever since).
Now, let’s look at two upcoming IPOs.
One IPO to avoid
Manchester United’s IPO is a must avoid. Man-U has lately lost players, lost games and is likely to lose on the NYSE too. Their source of revenue? Soccer! The soccer club has filed with the SEC to raise $100 million through an IPO expected in the coming month(s). Again, recall the intangibility principle from our Facebook example.
One IPO to consider
One IPO to consider, with controlled emotions of course, is that of Coty, Inc. You may recall Coty, Inc. from May headlines when Avon Products, Inc. (NYSE: AVP) turned down its acquisition offer. Coty Inc. manufactures beauty care products, cosmetics and perfumes. It holds a world class portfolio of famous brands including Calvin Klein, Chloe, Marc Jacobs, Davidoff, Playboy, Adidas and Rimmel. Coty also has a strategic partnership for the distribution of the perfume lines, including Prada and Shakira in the US and Canada. Coty is also set to launch the Lady Gaga perfume line very soon. The company has filed with the SEC to raise up to $700 million from the IPO, likely scheduled to be this month. By not letting their adrenaline overtake their critical thinking hormones (if there are any such), this is one company, unlike Facebook, that investors can objectively value based on the company’s tangible product lines.
While some may religiously follow Buffett’s advice, others may have their own tested recipe of winning from IPOs. Be on the lookout for promising opportunities! Happy investing!
PalwashaS has no positions in the stocks mentioned above. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.