Snapchat parent’s IPO valuation not a pretty picture

Snap, the parent company of photo-sharing app Snapchat, is set to make its stock exchange debut next month in what is the biggest US technology initial public offering (IPO) since Facebook went public in 2012. Investors will be hoping Snap can deliver spectacular Facebook-style returns but is it more likely to be the next Twitter?

Facebook shares have risen some 250 per cent since its stock exchange flotation; even more eye-popping is the fact that they have enjoyed an eightfold rise after falling below $18 in late 2012. In contrast, Twitter has proved a monumental disappointment, falling from a high of almost $75 in December 2013 to around $16 last week.

Wall Street is certainly excited about the Snap IPO. Technology IPOs almost invariably generate a lot of attention, given that they tend to be fast-growing companies that offer the prospect of being the "next big thing".

Fewer technology companies are going public these days – the last big one Alibaba in 2014 – so Snap’s launch is likely to be a much-hyped affair that stresses the company’s growth prospects.

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Bulls can point to revenue, which has soared seven-fold from $58 million in 2015 to $404 million in 2016; a devoted user base, with daily users visiting the app 18 times a day; and the fact that its advertising business is only getting started (revenue per North American user totalled $2.15 in the last quarter; Facebook’s equivalent figures are more than nine times higher).

Bears can point to slowing growth rates, noting that Snapchat gained five million daily active users in the fourth quarter of 2016, down from 10 million in the third quarter and 21 million in the second quarter; increased competition from a host of rivals, particularly Facebook; and the fact that while revenue is growing, so are losses. The company lost $514 million in 2016.

As its prospectus states: “We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.”

Stratospheric valuation

The fact that Snap is currently loss-making will not unduly bother investors as surging revenue means the company is expected to grow its way out of trouble. Whether it can grow into its current valuation is another matter.

Snap's valuation, expected to be in the region of $20-$25 billion, means it will likely trade on a price-sales ratio of 55. That's stratospheric: no major US flotation in recent decades has been afforded such a lofty multiple. Google, for example, traded on 10 times sales following its 2004 IPO. Facebook traded on 25 times sales in 2012, a valuation that left many investors aghast at the time.

As companies mature, their price-to-sales ratio invariably contracts. Marketwatch commentator Mark Hulbert points out that, after five years as a public company, Google's ratio had fallen to five, Facebook's to 11.

The median internet company trades at 2.8 times sales after five years, notes Hulbert.

If Snap’s price-to-sales ratio has declined to the same level as Google’s in five years’ time, its sales will have to grow more than 10-fold to justify next month’s expected stock price. That’s an annualised growth rate of 63 per cent. Between 1996 and 2007, says Hulbert, US IPOs averaged five-year revenue growth rates of 26 per cent annually.

Of course, investors don’t want Snap’s stock price to be the same in five years – they want it to be a lot higher. Hulbert calculates that for shares to average annualised returns of 15 per cent over the next five years, revenue would need to grow by 87 per cent annually. Note that Google and Facebook – two spectacular success stories – averaged annualised sales growth of 57 and 47 per cent respectively in their first five years as public companies.

It’s almost certain that Snap will not almost double its sales every year for the next five years. That means the only way it will prove to be a good five-year investment is if markets afford it a very lofty valuation in five years’ time.

Sexy or safe?

That's possible, but such bets rarely turn out well, as evidenced by a recent Stanford study, Sexy or Safe: Why Do Predicted Stock Issuers Earn Low Returns?

It found that the companies that are most likely to issue stock are firms with a history of loss-making, previous capital raises, high valuations and positive price momentum – essentially, fashionable glamour stocks that are strapped for cash. Between 1978 and 2013, the study found, high-predicted stock issue (PSI) stocks averaged returns that were “indistinguishable from treasury yields”. Annual returns for companies that were least likely to issue shares were roughly 10 percentage points higher, the study found.

High-PSI firms were nine times more likely to delist for performance reasons, with returns being especially poor during down markets.

The reason investors pony up cash for such stocks, the authors conclude, is because a handful of firms will deliver “lottery-like” returns. They are “sexier” to investors “and thus overpriced”. Most of the time, however, they end up disappointing.

As a general rule, buying into IPOs is a bad idea. One study that analysed more than 2,000 IPOs over a 17-year period found the median IPO was “significantly overvalued” relative to peers. Naive investors are “deceived by optimistic growth forecasts” and pay “insufficient attention to profitability in valuing IPOs”, the researchers cautioned.

Clearly, there’s more than a little merit to the old joke that IPO stands for: “It’s probably overpriced.” Irish investors will remember only too well the experience of Telecom Éireann.

IPOs tend to be bad bets, as do loss-making glamour stocks with hefty valuations. These findings, coupled with the fact that no major IPO in recent decades has looked remotely as expensive as Snap, mean it’s difficult to muster up much enthusiasm for the stock’s long-term prospects.

Of course, Snap may yet deliver the goods for investors, just as Facebook defied the doubters when it went public in 2012. Lucky investors may well take a punt and be rewarded for doing so, but that doesn’t mean it’s not a bad bet.