The Rocket Science of IPOs: Hype Is Not Fuel, It's Baggage

What to expect, and what to avoid, when considering IPOs.

By + More

The launch pad has been empty on most days since Facebook's disappointing initial public offering. Only four relatively small IPOs came to market in the month that followed its debut.

This quiet space is giving investors a chance to rethink their views on initial public offerings. Securities industry and government officials are taking a long, hard look at what happened when the much-hyped Facebook started trading. The huge offering snarled Nasdaq and disappointed investors as its market cap lost $20 billion in two days.

[Find Top-Rated Mutual Funds.]

Investors now should go back to the basics.

IPO launches work on simple Newtonian physics, rising on the fuel of buying demand and falling back on the gravity of selling pressure. On some rare occasions, the IPOs—often a mix of hype, investor optimism, and marketing—manage to reach the "friction-free" zone that is the domain of rocket science. Newtonian physics no longer apply. Rocket science takes over when there is no G-force to reckon with. Shares surge from day one without a pause. In reality, few new issues enjoy that ride.

Facebook was a dud because so many sellers were dumping the much-hyped stock that it was unable to sustain the expectations. The Nasdaq's failure to meet investor demand added to confusion.

Still, Facebook's high-profile woes don't mean its IPO was a failure, especially when viewed against how other newly minted stocks fare early on. University of Pennsylvania professor Jeremy Siegel studied IPOs from 1968 to 2000 and found that in nearly every year, they underperformed the small-cap benchmark index. Also, IPOs remain hugely valuable as they raise money for startups and promise huge rewards for investors along with risks.

"You have to see Facebook as a successful launch," says Sam Hamadeh, chief executive officer of Privco, which researches private equity and IPOs. "They managed to sell a lot of shares and raise a lot of money."

To be sure, companies with similar growth potential have soared in past IPOs and then entered that "friction-free" zone. How do you tell if the hype is greater than the sum of its IPO parts?

[See an ETF that tracks recent IPOs.]

Some companies with similar attributes to Facebook really did go into orbit after their launches:

Microsoft. Then-obscure Microsoft issued shares at $21 in an initial offering in March 1986. After nine stock splits, that single share became 288 shares with a present-day value of $7,200. A single lot, 100 shares, would be worth $7.2 million.

Wal-Mart. Shares were offered at $16.50 each in 1970. After 11 stocks splits, $1,000 worth of Wal-Mart's stock would be $1.8 million.

Apple. Offered in December 1980. Adjusting for splits, its initial stock price was $2.75. It is now worth $604.

Cisco. It went through nine stock splits in the decade after its 1990 launch, making its split-adjusted IPO price six cents ($16 now), and shares peaked in 2000 at $70. Arguably the best-ever tech IPO, Cisco shares had gained 100,000 percent at its peak.

All of these companies continued to grow earnings for years, of course. They also surprised investors positively over and over. Microsoft, Cisco, and Wal-Mart had years of unbroken quarterly profit gains. And they had either highly involved owners or employees who would acquire and hold large amounts of stock in employee ownership programs. Facebook fits most of these criteria, except for the boundless faith of investors.

Indeed, what the others also had in common was extremely low expectations when they went public—they were either largely unknown or rated as extreme long shots.

Wal-Mart was a discount store run by folksy chief Sam Walton, who charmed Wall Street into taking his stores public and charmed staff by flying in his Cessna to visit stores. He started out franchising Ben Franklin stores, which turned down his plan to create larger big-box stores. He started his own.

Nerdy Bill Gates and hippie Steve Jobs were college dropouts who had no real record of working for anyone. If you wanted, you could go back to a hard-of-hearing, often-fired misfit named Edison whose GE created thousands of shareholder fortunes.