Here’s The Reason Warren Buffett Didn’t Touch The Facebook IPO

Berkshire Hathaway held their annual meeting on May 5, 2012 of this year. During this meeting, Warren Buffett gave a response to a shareholder question, and he said:

“We should stay away from things we do not understand”.  He (Buffett) “needs to understand competitive position and and earnings power 5-10 years into the future.  BRK has not bought an IPO in 30 years.  IPO’s come to the market when sellers want to sell.  It makes no sense to spend 5 seconds on a new issue.  The idea that a new issue is going to be the cheapest thing to buy among thousands of stocks is crazy.”

Warren Buffett was clearly warning people about the upcoming Facebook IPO that went public on May 18.

Just three months after the Facebook IPO debuted at $38 a share, the stock is now trading at $19 per share on August 20, 2012, which is a decline of 50%. Do you know why the IPO failed? Is there a way for investors to avoid making this mistake in the future?

Business Insider contributor Dr. David Kass was invited on Fox News to discuss the Facebook IPO just recently on August 21. During his interview, he mentioned that the company was very difficult to value since there was such a high demand for the shares. After the first hour or two of the IPO’s release, the price of Facebook went from $38 a share up to $42 a share. It then immediately rose to $45 a share just a little while afterwards. From there, the price has steadily declined to its current level which is around $19 per share.

The supply of Facebook shares is also increasing because investors are selling their shares. There is also going to potentially be 1.4 billion more shares on the market on November 15, when Facebook insiders and employees have the ability to sell their shares after the lockup period comes to an end.

Dr. Kass also had a discussion about the quarterly earnings report of Facebook, which was recently released on July 26. Facebook actually reported a quarterly loss, due to increased expenses and slow growth in revenue. 84% of Facebook’s revenue during the second quarter was from advertising.

If you base the current $19 price of Facebook on valuation, then you’ll see that it’s actually selling 40 times higher than its estimated earnings of the next 12 months. To compare price and earnings of corresponding companies, Google is only selling at 20 times its yearly earnings. Apple is at 15 times yearly earnings and Microsoft is also at 15 times its 12 month earnings. To get a clear understanding of what this means, the market technically believes that Facebook is going to grow more rapidly than Microsoft, Google and Apple.

Is there any way that investors can avoid making an IPO mistake like this in the future? Dr. Kass mentioned in his interview that you should compare the price to earnings ratio of the new IPO with IPOs that were recently released in industries that are similar.

One question you should ask yourself is if all price-to-earnings ratios are comparable. You need to check and see how the recent IPOs that are similar performed. Did the prices of these recent IPOs decline once the initial public offering was made? Did the prices stabilized in these businesses, or did they even increase? If the upcoming IPOs P/E ratio is a lot higher than the recent IPOs that are comparable, then it would probably be a good idea for you to avoid the IPO altogether.

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