Warren Buffett And Lessons From The Facebook IPO

At the Berkshire Hathaway (BRK.A) annual meeting on May 5, 2012, Warren Buffett stated (in response to a shareholder question):

We should stay away from things we do not understand”. He (Buffett) “needs to understand competitive position and and earnings power 5-10 years into the future. BRK has not bought an IPO in 30 years. IPO’s come to the market when sellers want to sell. It makes no sense to spend 5 seconds on a new issue. The idea that a new issue is going to be the cheapest thing to buy among thousands of stocks is crazy.

This was a clear warning about the upcoming Facebook (FB) IPO on May 18.

Three months after the Facebook IPO at $38 per share, FB traded below $19 a share August 20, a decline of 50%. Why did this IPO fail? How can investors avoid a similar situation in the future?

With these questions in mind, I was invited to discuss the Facebook IPO on FOX News Channel 5 (Washington, DC) on August 21. I mentioned that there was a very large demand for the shares for a company that was difficult to value. Within an hour or two of the IPO, FB’s price rose from $38 to $42, and then $45. Thereafter, its price has declined to its current level of about $19. The supply of shares has also been increasing as early investors sold their shares. (Insiders, including employees, will be able to sell an additional 1.4 billion shares on November 15, when an important lockup period ends.)

I also discussed FB’s latest quarterly earnings report, which was released on July 26. FB reported a quarterly loss, slowing growth in revenues, and increasing expenses. FB derived 84% of its revenues from advertising in its second quarter.

In terms of valuation, at FB’s current price of $19, it is selling at 40 times estimated earnings over the next 12 months. This compares to corresponding price earnings ratios of 20 for Google (GOOG), 15 for Apple (AAPL), and 15 for Microsoft (MSFT). Since price earnings ratios are generally correlated with projected growth rates in earnings, the market today is projecting higher growth rates for FB than for Google, Apple, and Microsoft.

How can investors avoid a similar IPO mistake in the future? I recommended during my interview that they compare the projected price earnings (P/E) ratio of the proposed IPO with other recent IPOs in the same or similar industries. Are the P/E ratios comparable? How did the recent IPOs perform? Did their prices decline substantially after their IPOs, or were the prices stable, or did they increase? If the projected P/E ratio of the upcoming IPO is very high relative to comparable recent IPOs, perhaps this new IPO should be avoided.