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W&L Professor Advises Caution with Facebook IPO

By Adam Schwartz
Lawrence Term Professor of Business Administration

The Facebook IPO reminds me of two pieces of advice to avoid “classic blunders” from the character Vizzini in the movie “The Princess Bride.” As he tells the Man in Black: “The most famous . . . is ’never get involved in a land war in Asia,’ but only slightly less well-known is this: ‘Never go against a Sicilian when death is on the line!’ “

For finance, there are two classic blunders: Entering a market buy order for an IPO at the open on the first day of trading, and paying a multiple of more than 50 for any stock without a strong earnings growth story.

Researchers have shown IPO shares to underperform the market. In a study of 7,531 IPO offerings from 1980 to 2010, Jay Ritter, the Cordell Professor of Finance at the University of Florida, finds that the newly issued shares underperformed the market index by almost 20 percent in their first three years of issue.


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You might counter, “Well, some IPOs go up 100 percent on the first day.” True. There is sometimes an initial run-up on the first day. If the IPO is worth owning, you won’t get any shares at the initial price. Your market order will usually fill after the run-up has occurred (over $40 for Facebook, if I remember correctly).

I would avoid IPOs in the first few months after issue before the lock-up restrictions are lifted. Facebook investors are well aware that an additional 1.3 billion shares of the stock will be eligible to trade in November.

The biggest reason for the Facebook drop is simply that it was overpriced. Facebook trades at a very high multiple and doesn’t pay a dividend. Even at a price of $20, Facebook is still trading at almost 69 times earnings. Other high-growth tech stocks don’t trade at such a high P/E multiple. According to Yahoo Finance, awesome Apple trades at only 15 times earnings, and Google at only 20 times earnings. Facebook trades at a high P/E multiple, because the market is expecting a great deal of earnings growth. If that growth doesn’t materialize, the multiple of Facebook stock might fall.

The price of a stock is equal to the earnings times the P/E multiple. There is a great deal of risk even at $20 a share. If Facebook doesn’t post great earnings for several quarters, the price could drop lower still.

Although I’m not always right, I would personally rather hold shares in an S&P 500 index fund than Facebook shares at the current price. I don’t see how they can grow fast enough to justify a multiple of 69, unless they come up with a better revenue model—or a planet without a social network pulls up next to