Avoid IPO Madness

Timothy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The life cycle of the typical IPO seems to be this: the stock shoots up on the first day to outrageous levels, stays there for a time as it's propped up by nothing more than enthusiasm and hope, and then eventually crashes when people realize that the business model isn't as bulletproof as they had originally assumed.

The second stage of this life cycle is a dangerous one. The very fact that the stock trades at an elevated level for so long lures some into thinking that the valuation is reasonable. It often isn't, and those paying 50 or 60 times earnings expecting phenomenal growth are almost always shocked when the stock comes back to reality.

Paying too much for stock photos

Last October a company called Shutterstock (NYSE: SSTK) made its debut on the New York Stock Exchange at $17 per share. Shutterstock is an online marketplace for digital imagery which sells subscriptions that allow users royalty-free access to over 25 million stock images. Since its IPO the stock has shot up well over 200% and now trades for around $55 per share, valuing the company at roughly $1.9 billion.

Revenue grew by 42% to $170 million in 2012 as net income jumped by 118% to $48 million. That would put the P/E ratio at about 40, but unfortunately it's actually far higher than that. You see, there was a one-time tax benefit related to the company reorganizing from an LLC to a C-corporation in 2012. If this benefit is backed out, as it should be, net income was really only $28 million for the year. Earnings growth was really only 17%, and the real P/E ratio is a staggering 68.

There's another problem. The barrier to entry in the stock photo industry is essentially non-existent, as anyone can assemble a collection of photographs and sell them online. Shutterstock has plenty of privately-held competition, with iStockphoto.com being one of the biggest. The quality of the images seems consistent across both sites, which means that the lowest price will likely prevail. There's nothing truly unique about Shutterstock to differentiate it from the competition, and this will inevitably lead to margins going down. The company sells what is essentially becoming a commodity, and there's no real money in that.

Profits will not grow fast enough to justify paying nearly 70 times earnings, and even at half the price the stock is still outrageously priced. This is not a $2 billion company.

Investing in Soccer

Soccer, or futball, is the world's most popular sport. It is played by an estimated 250 million people worldwide in more than 200 countries, and professional teams have some of the most dedicated fans in all of sports. Manchester United (NYSE: MANU), an English club, is the most valuable sports team in the world, valued at about $3 billion after its IPO last year.

Manchester United has an enormous following worldwide, and the company makes its money through sponsorships, merchandising, and broadcasting deals. The problem is that Manchester United is already so popular a club it's hard to imagine it getting more popular. Where, exactly, is significant future growth going to come from? Revenue actually decreased in fiscal 2012 compared to 2011, and with a TTM net income of 25 million GBP the company trades at an astonishing 75 times earnings.

Another problem is the company's significant debt. With about 370 million GBP in debt the company paid 50 million GBP in interest in fiscal 2012. While the debt is being reduced this interest eats up a big portion of the profits.

One problem with an investment like this is that the company's revenue is tied to the team's performance, and if the team has a bad year revenues will likely suffer. New licensing deals are certainly possible, which would boost revenue, but there's no reasonable justification for the nosebleed valuation.

Noodles

Casual dining chain Noodles & Company (NASDAQ: NDLS) shot through the roof on its first day of trading and is now valued at around $1.3 billion. I wrote about the Noodles concept previously, concluding that the company is unlikely to be the next Chipotle or Panera. Noodles recorded a net income of $5 million last year, which means that the stock trades at well over 200 times earnings. In fact, the stock trades at about 80 times the expected earnings for 2014. Even if Noodles were the next Chipotle that company took 20 years to get where it is today.

It's hard to imagine, even in the case where Noodles becomes extremely popular, that the company can grow fast enough to justify this kind of valuation. The success of chains like Chipotle and Panera have clouded the judgement of investors. Not every casual dining chain is going to be that successful. And I don't think Noodles has what it takes.

The bottom line

When irrational expectations are the only thing propping up a stock price it's a good idea to stay away. Time is the enemy of an overpriced stock, and these three stocks will fall back to reality one way or another.

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Timothy Green has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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