GO
Loading...

Facebook IPO: How Stock Offerings Help the Economy

Thursday, 17 May 2012 | 1:37 PM ET

Everyone knows they can make a killing if they get in on the ground floor of an initial public offering. But what about afterwards?

Facebook Stock Certificate. Click image to view larger.
Source: SEC
Facebook Stock Certificate. Click image to view larger.

While the Facebook IPO is unique in size, investors are anxiously weighing the same critical questions they do each time a new company comes to market: is the IPO just a way for company founders and venture capitalists to cash out, or does it offer value both for the portfolio and the economy as a whole?

Economic research suggests that the answer to both questions is that it depends critically on company size and timing. Even then, there isn’t much extra value in the IPO process after the first-day of trading.

Overall economic value is harder to measure. But University of Chicago Booth School of Business Finance Professor Steven Kaplan says the IPO process is critical to the economy’s ability to generate wealth and innovation.

Some 600,000 companies are started every year, of which only about 1,000 get funding from venture capitalists. Only about 100 companies ever get to the IPO stage annually.

But Kaplan argues it’s the very prize of being able to potentially cash-out that helps provides the incentives for entrepreneurs to start businesses in the first place. So a healthy IPO market can be linked pretty directly to overall economic innovation.

At the University of Florida, Professor Jay Ritter has studied the job creation of newly public companies. Ritter’s work shows these IPO firms tend to be job factories. Looking at IPOs from 1986 through 2000, Ritter found that they added 822 employees on average for 60 percent growth in employment over a 10 year period.

Looking at what Ritter calls "emerging growth companies," which excludes some older companies that have come to market, Ritter found any eye-popping 161 percent surge in employment over a decade.

This contrasts with a study of Italian IPOs that found little added economic value, at least in that country. The study found that companies there mostly came to market to take advantage of beneficial market prices or to change their company’s capital structure, that is, usually taking out debt and substituting with equity. The study found little gains in capital investment.

Similarly, it’ shard to find economic value in at least one of the stated uses of the IPO proceeds: paying taxes associated with Facebook Founder Mark Zuckerberg’sexercise of a 60 million stock option. The treasury of the state of California looks like the big winner there and that economic value proposition is, at best, debatable.

But there is another benefit to the IPO process: it puts an open market to work at determining the value of Zuckerberg’s shares in a continuous feedback process.

While valuation in the private (that is, non-public market) sector has improved over the years with new innovations and secondary markets, economists still say the broader open market is best at determining value. In part, that’s because liquidity premiums and discounts, which can distort a share’s price, are usually not a factor. What remains is the intrinsic value of the stock as determined by willing buyers and sellers who can move in and out of the stock without changing the stock’s price.

So how well do investors do when it comes to investing in IPOs? Ritter’s work shows size and timing are critical. Investors who get in on the IPO before they trade publicly see an 18 percent return. Those who get in afterwards, get returns of about 21 percent three years later. Sounds great, right? Not so fast. Over the period of 1980-2010, that 21 percent return would on average have trailed the market by 20 percent. In other words, investing in the broader market rather than IPOs would have made your portfolio much healthier.

So IPOs are terrible, right? Not so fast again. It depends on the size of the IPO. Three years after the public offering, small IPOs, those with revenue less than $50 million, trailed the market by 35 percent. But large IPOs, with revenue in excess of $500 million, beat the market by 2.6 percent, according to Ritter.

Those last numbers may provide a clue to the overall economic value of IPOs. The smallest ones seem to indeed be cash-outs and/or just more speculative. That’s part of the reason that there has been a decline in smaller offerings as investors have gotten wise to the lackluster returns.

But big IPOs, which beat the market by 2.6 percent, seem to add value and earnings on pace with the rest of the market. So the venture capitalist and the founders may be cashing out, but they appear to providing value to investors and the economy as a whole.

-By CNBC's Steve Liesman
@steveliesman