Friday, August 17, 2012

IPOs and Corporate Equity

When Facebook debuted as a publicly traded company, the initial valuation of the company was 81 billion dollars. Its current share price (as of 8/16/12 market close) has the company pegged at 42 billion.

Since its public debut, people have come out of the woodwork to criticize and deride the handling of Facebook's IPO. And Facebook's own employee shareholders have voiced concerns about the stock price. And yet, from the standpoint of the company, it's hard to see how it was anything but a resounding success.

It's a rule that a company's executive management should have the company's owner's best interests in mind. That means keeping an eye on the bottom line, making sure that the company is making as much profit as possible. Due to how the current understanding of how companies are valued (based on future earnings), that usually translates into high share prices.

Well the share price has since halved. So it doesn't look like the owners have been well served by Facebook's management team. But the company raised 16 billion dollars by selling about 20% of the company at a share price that was overvalued. So the company made out like a bandit, because it sold an overvalued asset (itself) before people realized that the company was worth much less than the IPO price.

Now the company has around 16 billion in cash reserves, waiting to be invested in a worthy project (that, presumably, will be more profitable than just Treasury bonds). If the IPO valued the company at 20 billion dollars and the share price doubled to what it is now, the public perception of the IPO would be much better. But then the investment bankers who underwrote the IPO would have caught flak for undervaluing the company by a huge margin.

What people lose track of is the reason why companies go public is to raise capital. From the company's standpoint, the goal of the IPO is to raise as much money as possible. So from that standpoint, Facebook's IPO was a resounding success. In nominal terms, it was the 3rd largest IPO in US history.

I think the reason why people have lost perspective on the IPO is because people have lost perspective on corporate equity in general. All a share represents is a claim on a company's future profits. And if the company doesn't redistribute its profits in the form of dividends, then a share in the company is effectively worthless.

Microsoft, the original tech titan (sorry, IBM), went 17 years before issuing its first dividend. Now, if you were playing a long game, then Microsoft's management team was able to deliver tremendous value to its initial shareholders. But if you bought MSFT in 1986 and sold it before ever receiving a dividend, you were essentially relying on a greater fool to buy the stock off your hands because they were hoping to receive a dividend.

There are countless instances in business history where a company past its prime spends a lot of cash in the futile pursuit of outsized profits. All too often, these companies just end up wasting money that could have gone back to shareholders in the form of dividends. But even when this happens, there are still plenty of investors out there who believe that a company that isn't reinvesting its profits (as opposed to distributing it to its shareholders) is past its prime.

Collectively, we've (and by we, I mean the business savvy minority of the country who actually invest serious money in the financial markets) lost sight why equity exists in the first place. Or maybe we (same group) are just trying to game idiotic retail investors.

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