Facebook went public less than two weeks ago and there are plenty of lessons investors can glean from that event. You probably already know what an IPO is. It’s simply the first offer to sell shares of a company directly from the owners. And unless you live under a rock, you already know that the IPO was widely expected to be a huge success. But after all the dust settled, the offering actually fell on its face.
The shares were offered on the IPO at $38 shares. The price did shoot up to $45 during the first day of trading, but then settled back to $38.15—only a tad more than its public offer. Over the next several days the shares continued to sink and as of May 30 the shares were offered at less than $29, which is more than 23 percent below what people paid who got in on the IPO.
What went wrong?
Because of the sheer volume of trades, there were some glitches. But with respect to the drop in price, nothing went wrong. The market functioned perfectly. If anything “went wrong” it was the expectations that investors had about the IPO. Most of the people I spoke with regarding these shares expected a huge initial spike in the price. In fact, most of the people who wanted me to buy Facebook shares for them on the IPO considered the IPO a “can’t miss” investment.
As a result of the Facebook dud, I think we can all derive a few very important investment lessons.
1. There is no “can’t miss” investment.
As much as you think you “know” something is going to happen, you can never be sure. This goes for stocks, options, gold, and/or real estate. There is always a chance (sometimes a very good one) things will go wrong. Make sure that you only invest in those deals where you understand what the downsides are. And make sure you can live with the consequences if things don’t go your way.
2. You can’t predict the stock market, especially over the short run.
People pay lip service to the concept of not being able to predict the stock market, yet they often act as if they can predict it. Did you know that for every share that was brought to the IPO market, there were 10 shares that were ordered? With such a huge over-subscription, you’d expect the shares to skyrocket once they hit the open market.
They didn’t because most of the people who put in orders for the IPO didn’t really want to own shares for the long haul. They all believed that they’d make a tidy profit by simply buying the shares on the IPO and selling them on the open market. But what happened was that very few people wanted to buy shares on the open market. They only wanted them on the IPO for the quick hit. That’s why shares fell so quickly.
There is no magic when it comes to any particular stock – no matter how much you like the company. People often make the mistake of thinking that some stock is special and it will defy the market. This happens time and time again. In fact, some people still feel this way about the price of gold. Others feel this way about shares in Apple. What we learn from the debut of Facebook is that you really don’t know what’s going to happen with the market.
3. An IPO is not a golden ticket.
Investors often believe that if they can get shares on the IPO before the company goes public, they have an automatic profit. That is not true. As a matter of fact, many great companies that went public recently lost a bundle for the people who bought shares on the IPO. Facebook is only the most recent example.
4. Earnings drive prices
At the end of the day, the price of a stock is a function of the company’s earnings. If a firm’s earnings are rising, the stock price will follow all things being equal. I spoke to a great many people who wanted to buy Facebook. Not one ever asked me what was happening to the firm’s sales or earnings. Yet it was common knowledge that both were slowing. Few people asked if the price of the shares was in line with earnings projections. But had they asked they would have learned that the shares were extremely overvalued. This is not to say that Facebook shares won’t rise in the near-term. They could. But if the share price is to remain elevated, earnings are going to have to accelerate quickly.
5. Does it pay to take a risk?
There is nothing wrong with taking a calculated risk with an IPO. Indeed, the people I spoke with about the IPO could afford the risk and knew what they were doing. But before you take a plunge on IPO shares, make sure you are aware of the risks. And make sure your long-term investment plan is based on a sound investment strategy. Don’t rely on your gut feeling about a particular stock or commodity.
Neal Frankle is a Certified Financial Planner in Los Angeles and owns Wealth Pilgrim – a personal finance blog. His most recent blog post was his Perkstreet Review.