how to invest in new stock ipo

IPO Stocks [How to Value Any Company and When to Buy]

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Venture capital analyst shares his process for investing in new stock IPOs

The hot new stock IPO is out but is it going to be like Facebook which has jumped five-fold since its IPO or a total bust like so many others?

Investing in initial public offerings (IPOs) is one of the hottest topics but also one that is largely misunderstood. Some investors love jumping into a new stock while others say they'll never do it.

In this video, I’m sharing the exact process I used to value IPO stocks for venture capital investors including the two valuation methods that tell you how much a stock is worth.

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How the Smart Money Invests in IPO Stocks

This is a video I’ve been wanting to do for a long time. I worked as a venture capital analyst for years, valuing private companies and pre-IPO stocks. I created and managed a team of analysts for a Canadian VC firm. If you want to know how to make money investing, it’s this kind of early-stage investment that produces double- and triple-digit returns.

I planned on doing the video around one of the big IPOs this year but I didn’t want it to be specific to any one company. Those videos like, Should you invest in the Uber IPO or this or that IPO, are hugely popular but you’re pretty much stuck after that.

Instead, I want to give you the tools you can use to value any stock IPO. I’m going to show you the exact process I went through to value a private company before its initial public offering. I’ll reveal the valuation methods I used that told me exactly how much a stock would be worth and whether to buy at the IPO price or to wait.

And trust me, you do not want to be wrong here. IPOs can provide spectacular returns but many lose money from the start. Research by Renaissance Capital shows that almost half the new IPOs trade lower by the end of the year and one-in-four lose money on the first day.

To show you how to value IPOs, I’m going to be using the same process I used in a 2015 report to private investors for a funding round in Pinterest. I was hired to provide a valuation for investors in what turned out to be the social media giant’s last big funding round before it went public at a $14 billion valuation.

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What is the IPO Process?

First, I want to talk a little bit about the IPO process, how a company sells shares. I also want to point out a few of the reasons why I generally wait after the IPO to buy a new stock and how you can use the analysis I’ll outline to find the right price to buy.

By the time a company files to issue stock in the public market, it might have been around for a decade as a private company. In fact, most companies are acquired rather than have an IPO. In my work as a venture cap analyst, I’d say maybe one out of ten companies would eventually IPO shares.

For example Facebook raised money for the first time in 2006 but would go through 14 funding rounds from private investors before its IPO in 2012. It raised just over $2.3 billion in private funding and was valued at $104 billion when it issued public shares.

So that IPO made early investors filthy rich. One of the first private investors, Peter Thiel turned a $500,000 investment into a billion dollar payday.Why You Might Not Want to Invest in IPOs

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Why You Might Not Want to Invest in IPOs

But this is one of the reasons why you really need to know how to value a company at its IPO. By the time a company gets to this point, the private investors have sucked just about all the value they can get out of the investment. That’s what they do, looking for companies that can grow cash flow to be sold off or issue shares, and as an analyst that’s what I helped them do.

Another reason I’m generally skeptical of buying in on a new IPO is what’s called a lock-up period. Understand that before a company issues stock, besides all these private venture capital investors, it’s also sold shares to employees and large institutional investors.

To keep these from dumping their shares at the IPO for that quick jackpot, companies have a lock-up period of between three to six months that insiders and early investors can’t sell their shares.

The problem is that when the lock-up period expires, you get a lot of people looking to sell their shares. Obviously not everyone is going to dump all their shares but it can still be a big wave of shares on the market for months and just simple supply and demand factors here. When you have a lot of supply, so lots of shares trying to be sold, but demand stays the same, then prices have to come down.

We see a good example of the lock-up period problem with Alibaba. Its lock-up period ended March 2015 and at this point just the employees and insiders owned 437 million shares or about 18% of the company.

stock ipo lock-up period
IPO Stock Lock-up Period Example

So you see here for about four months, the share price had a really tough time breaking higher because you had a big wave of sellers trying to unload some or all of their shares.

So two reasons you need to be extremely skeptical of buying new stock in an IPO, two reasons you absolutely need to do the analysis and know the fair price for those shares.

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How to Value IPO Stocks

Let’s walk through that valuation process you can use for any new stock or IPO. This is the process I used to value Pinterest in 2015 on its Series G funding, just four years before it issued shares.

There are four parts to the process I used to value early-stage and IPO companies. You first have your qualitative analysis so you’re looking at the industry and competitive landscape. You’re looking at profits and positioning of similar companies already in the industry. Then you’re going to look at the strategic focus of your IPO target and management’s ability to deliver on any advantages.

I’ll be making another video detailing this part of the process, how to really understand an industry and do this deep analysis. For the rest of this video, we’ll focus on the valuation side using two methods that I’ll share.

Next you’re going to dig into the company’s financial statements and build a cash flow model. This is where I would take management’s forecasts for growth, which are ALWAYS overly-optimistic by the way, and build out a realistic expectation for cash flows and income. I’ll be doing this in another video as well because I want to get to these next two steps.

These next two, the mergers and acquisitions valuation and the comparables valuation, are where you really start to see how much this new stock is worth. I’m going to show you exactly how to put these together using public information to estimate a fair value for an IPO stock.

So there’s two methods we’ll look at, the M&A or mergers and acquisitions method. This one looks at how much companies are paying to acquire a similar company to the one you’re valuing. In our Pinterest case, we’ll be looking at acquisitions in the social media space to estimate how much the company is worth based on sales and monthly users.

The other method is done on competitor multiples, so looking at other publicly-traded companies to see how much they’re trading for on a sales or active users basis.

Let’s look at the table here showing us that M&A method for Pinterest and I’ll show you how to put this together but I want to point out a few things first. This first column is the date the acquisition was completed so the date the buying company, the acquiror, was saying that this target company was worth this much.

How to Value Stock IPO
How to Value Stock IPO

Next we have the industry in which the target company operates. This is important because like we’ve talked about before on the channel, you have to compare stocks with similar companies in the same industry. For our Pinterest example, we’ll look for other acquisitions of social media companies.

The next two columns are self-explanatory, the target company and the acquiror, followed by the transaction value. This is the total price paid to buy the target company and you want to make sure this includes the value of cash, stock and any debt. Finding acquisitions to compare in your IPO analysis is pretty easy. You can do a search in Google for the name of the industry and acquisitions and then just look through the results for lists of past deals.

These last two columns are the most important and this is where you’re going to get that company valuation. You want to get an idea of how much acquirors are paying for the sales and other financials of those target companies. Sales or revenue is a common measure and sometimes you’ll see earnings before interest, taxes, depreciation and amortization or EBITDA in this second column.

Here’s where you need to know about the industry though and where some of that market analysis comes in handy. Here since I know that monthly active users is one of the most important measures for a social media platform, I’m going to find the value on these deals according to how many users the platforms had at the time of the acquisition.

Finding these deals is easy with just a Google search for the industry then acquisitions. The part where you’ll have to do a little research is to find the revenue and your other measure at the time of the acquisition. For example, when I did a search for Social Media acquisitions, I found a couple of articles that listed out all six of these deals but none of them showed revenue and only a few showed the monthly active users statistic I needed.

To fill out the table, I had to search Google for things like the target company’s name and revenue or the target company’s name and acquisition valuation. So this will take a little more time but you can usually find the estimates for your table.

Once we’ve got the sales and active users for each target company, then you can take the transaction value so that deal value and divide it by the number. For example Yahoo bought Tumblr for $1.1 billion in 2013. Tumblr booked about $13 million that year and had approximately 300 million users. So we took that $1.1 billion divided by 13 million in revenue to get the 84.6 number you see and the $1.1 billion divided by 300 million monthly active users for that 3.7-times multiple.

We find that transaction value multiple for each deal then you see I’ve created some summary stats here below. I like to list these out below, the average, median, the highest multiple and the lowest. Being able to see it here gives you an idea of how close the deals are, you can see which were the highest and the lowest.

Then you have to question why, why was Microsoft willing to pay so much more per sales and per users for Yammer in 2012 than it did for LinkedIn in 2016? And while you’re asking these questions, you start thinking about how closely your new stock IPO compares to these deals. Is it pretty much like the average or does it have a competitive advantage that might mean its valuation should be at the high end?

Generally, I’ll use the median multiple here and apply that to the company we’re analyzing. Because there’s quite a bit of variation here, I decided to go with the multiples in the LinkedIn deal. Both LinkedIn and Pinterest are relatively well-developed platforms compared to some of these other targets. The LinkedIn deal was the latest so it’s probably a little more applicable to today’s values.

So if we take the multiples on the LinkedIn deal, this 9.5-times sales and 60.5-times monthly users, and we multiply those with the estimates we have for Pinterest for about $1.06 billion in 2019 revenue and 291 million monthly users, we get this estimate of value from about $11 billion to $17.6 billion.

Now that’s still a pretty big range but I’ll show you how to narrow it down after we walk through our second valuation method but this gives us a start on valuing our new stock.

The second way we can value an IPO or a new stock is by comparing it to similar companies already trading on the market. This is called the public comparables or market approach. Here you see the table and this one is going to be slightly easier than the M&A approach. You first do a Google search for publicly-traded companies plus the industry so here it was pretty easy to get a list of five social media companies with shares available.

How to Value IPO Stock
How to Value IPO Stock

Next you can go to any investing platform or Yahoo Finance and find the rest of your information. You’ll find the market cap of the company which is the share price times all the shares outstanding, so the total market value. You can look on the company’s financial statements to find its revenue or sales for the last year. Here I had to do a search to find the current data for monthly active users on each platform.

Again, usually you’ll use sales and EBITDA for these two columns but I knew from my research that monthly active users was a better measure so I decided to use it for valuation.

You do the same thing here as in the M&A model. You take your market cap of the company and divide by the metrics you found. For example, Facebook books roughly 56 billion in annual sales and has 2.38 billion monthly users. Taking this $524 billion market cap divided by each of those numbers gives me the 9.4 multiple and the 220-multiple you see here.

Again you can show the summary stats below and it’s kind of all over the place. Investors are paying about nine-times sales for established platforms like Facebook and Twitter while Snap gets a little higher valuation and Yelp is in the doghouse.

The multiples on monthly active users are really revealing here. For platforms like Facebook and Twitter which have their monetization down, they know how they’re making money off users, investors are paying much more per active user. On the other hand, for platforms like Snap and Yelp which haven’t really figured out quite as well how to make money, investors aren’t paying nearly as much per user.

Here I decided to use the price multiples for Snap because I feel like it and Pinterest are very close in their life cycle. Both have a high number of monthly users but have struggled a little to find ways to monetize that base. Growth is stronger on Pinterest though sales are a little higher on Snap.

So when we use that 12.1-times sales multiple and the 53.1-times MAU on the data we have from Pinterest, we get these two estimates for $12.8 billion and $15.45 billion.

Now I know what you’re saying, we’ve got two different valuation methods, each with two estimates on the value of Pinterest. Which is it? How do I know what is a good price for this stock?

This is where you use a little of that market analysis on the company and put together what’s called a blended valuation. So if you look at the two methods, you get a low estimate around $10.1 billion and a high around $17.6 billion. Taking the average of the two, you get a low around $11.5 billion and a high around $16.5 billion and an average centered right around $14 billion which is where Pinterest is trading now at just under $26 a share.

So we have an idea that fair value is right around where the stock is trading. Now we look at growth and that competitive positioning from our market analysis. Growth in revenue and monthly users is stronger than a lot of the other social platforms. I like the fact that Pinterest has elements of search in it’s function rather than just a social platform. I think it makes it much more monetizable and less susceptible to competition compared to pure social platforms like Twitter and Snapchat. I think the revenue growth is there, like that comparison to Facebook, Pinterest just needs to prove its monetization plan.

Take all these together and you can make an argument that the shares should be worth the top end of those estimates rather than towards the bottom and a good deal from here. Now if you were doing this on a new stock waiting to IPO, it would be no different. You would have the proposed IPO share price and a market cap for the company to use in your analysis.

how to invest in new stock ipo

Investing in new stock IPOs can be some of the best returns you ever make or it can destroy your portfolio. Being right means understanding how much shares are really worth and being able to see through the market hype. Learn the IPO process and how to value new stocks before you lose money.

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