Tuesday, 28 August 2007

Sucker for a story, or, Why you should never buy an IPO

Anyone who has attended one of my behavioural finance speeches will probably have heard me talk about the dangers of stories (Chapter 15 of Behavioural Investing) , and use IPOs as an example. I point out that IPOs have usually got wonderful stories attachted to them, but statistically they are a nightmare investment. In chapter 7 of Behavioural Finance, I present a mass of evidence that shows on average IPOs underperform the market by around 30% over the three years after their listing (after their first day of issue).

Generally during the speech I also talk about need to reverse engineer valuation to avoid anchoring on market prices. That is to say, take market prices and back out what they imply for growth, and then assess whether there is any likelihood of that expected growth being delivered (Chapter 2 of Behavioural Investing).

A new paper by Cogliati et al (available here http://papers.ssrn.com/sol3/papers.cfm?abstract_id=965450) combines these two observations. They examine some 168 IPOs that took place in the UK, France, Italy and Germany between 1995 -2001. Because of their methodology Cogliati et al end up with a sample that has actually larger and older IPOs than the average seen across the exchanges that they covered. So their results don't just reflect the explosion of small cap tech stocks seen in the dot.com boom. Additionally, as a result of this the results uncovered are likely to understate the true picture!

Cogliati et al reverse engineer the growth rate in free cash flow implied by the IPO listing price. They use a two stage DCF model with a five year abnormal growth period, before growth settles down to GDP. On average, the IPOs in their sample show an implied growth rate of nearly 20% p.a. !

The chart at the start of this entry shows the implied free cash flow growth rate for years 1,3 and 5 against the actual delivered growth rate. To say that IPOs fall enormously short of investor's expectations would be a gargantuan understatement. Far from delivering 20% growth in FCF in year one, most IPOs continue to have negative FCF. Even by year 5, they are showing a paltry 3.7% FCF growth, a far cry from the 20% expected at listing!

Cogliati et al use the realised cash flows to estimate a true 'fair value' for the IPOs in their sample. They find that the listing price is on average 70% above their intrinsic value calculations!

Focus on the facts, not the stories!

2 comments:

Morgan said...

Exactly! IPOs provide an excellent exit strategy for cashing out. Just as Paul Sonkin et al say in Value Investing, "the firm being taken public makes a strenuous effort to put it's best face forward. It can freeze hiring in the year before to show a decline in expenses. Other discretionary spending will be deferred, and revenue will accelerated wherever possible."

Always need to avoid IPOs.

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