Daily Gains Letter

Should Stock Market Investors Avoid IPOs?

By for Daily Gains Letter |

IPOThere’s an ongoing debate over whether the stock market is overvalued and vulnerable to a bigger correction than we have seen in the recent year. Based on the earnings growth, the valuation of the stock market may be somewhat high, but pricing is more based on the prospects going forward. One area in which investors need to beware of valuations, though, are in the newest IPO debuts.

Pre-IPO Valuations Utterly Ridiculous

What really concerns me is the insane valuation given to many of the venture capital–backed pre-initial public offering (IPO) companies. In my view, the valuations are not sustainable and deserving; albeit, there is so much froth swirling around here.

Take the case of Uber, the provider of private car services that is trying to take the world by storm and push out the traditional taxi and car service companies. It’s a good idea, but the service is not always the cheapest and could rise in cases when demand is high. Based on the venture capital market, Uber is worth upward of $25.0 billion, which is utterly ridiculous.

I just read about a similar car service app in Hong Kong that is valued at around $8.0 billion. Again, insidious valuations.

The stock market climate for hyped-up pre-IPOs is extremely frothy. Last week, cloud-based service provider GoDaddy Inc. (NYSE/GDDY) debuted at $20.00 and surged more than 30% on its first day. While the company has a great advertising team, I really question the valuation. The company is a money loser, yet it’s now assigned $4.02 billion in market cap by the stock market. I wouldn’t be jumping in.

Then there’s gourmet hamburger operator Shake Shack Inc. (NYSE/SHAK), which began as a one-person cart in New York City. The stock market believes it is worth $543 million, trading at a whopping 543X its 2016 earnings per share (EPS) and with a price-to-earnings growth (PEG) of 30. This even makes momentum stocks like Facebook, Inc. (NASDAQ/FB) and Twitter, Inc. (NYSE/TWTR) seem cheap by comparison. With a mere 63 outlets in Shake Shack’s chain (only 31 are corporate-owned), the valuation is way too rich.

Why Investors Should Be Cautious of IPOs

My point is that investors need to be aware of the extreme stock market valuation in some of these IPOs and understand that they are vulnerable to selling on bad news.

Take the case of cloud storage company Box, Inc. (NYSE/BOX). The company surged on the growth for cloud stocks, but then reality eventually set in. The stock traded as high as $24.73, but has fallen to $18.67 and may be potentially heading even lower. Revenue growth is decent at 30%, but the company is another money loser and recently fell short of Wall Street expectations. Box is now looking to expand its focus to management software, moving away from the cloud. Perhaps a red flag?

My take is that we are seeing some froth in the stock market. It may not be like it was in 2000, but nonetheless, there are some questionable valuations, specifically in the venture capital pre-IPO end.

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