The Snapchat IPO and California math: Column

In Extraordinary Popular Delusions and the Madness of Crowds, Charles Mackay in 1841 suggested that the key to a scam or delusion is to make it big enough to erase all doubt. Outsiders buy into the perception that they are somehow missing something in any reasonable analysis of an investment opportunity. So, a kind of veil is created. Implied is that those who are greatly endowed have a secret vein of knowledge that the less endowed are not capable of discerning.

This reminds me of California today. A very nice place with nice people and neat landscapes — great surf too. Many legitimate companies. When we started Sageworks, we did a couple of pivotal deals with companies there that helped us start our company. So, this article is not an attack on the people there, but rather, it’s a starting point to looking at the entire world view of the people there who have benefited from the success of some great companies but who are in actuality simply just posers.

Of course, posing in itself is not a huge problem. If I own a lemonade stand that does $100 in revenue per year, and I, as the owner, believe that it is worth $1 billion, that is not necessarily a problem. It's like my saying I am as good-looking as Brad Pitt — I harm nobody. Self-delusion only becomes a problem when it invades another's boundary. So, the problem begins when I ask someone else to invest or lend me the $1 billion, when I accept other people's money.

Snapchat was founded in 2011. Its revenues were $404 million in 2016 and $59 million in 2015, a one-time increase of 590%. There is no doubt these are good growth numbers. However, it lost $611 million in cash from operations and generated a net profit loss of $515 million in 2016.

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In startups, you look for a big market with strong growth and a sticky product. But this is no longer a startup. Snapchat is now going public and current shareholders will go from bearing 100% of the company’s risk to something less than that. That is what an equity investment is — a transfer of risk from one party to another. One person bets long; the other person sells. The problem is that this company will no longer be using its own money for growth or shareholder return — it will now be using the funds of the investing public. Keep in mind as well that their product is basically a trendy idea, which is subject to the whims of the generation of people they appeal to. Therefore, it is very difficult-to-impossible to accurately forecast their long-run prospects, which should be the basis for good investing.

Consider tech companies such as Twitter, Groupon and Zynga, among others. Investors who bought Twitter at its IPO in 2013 paid $26 a share. This week, it’s trading at around $16 a share, a decrease of almost 40%. Similarly, investors who bought Groupon at its IPO in 2011 paid for a $20 billion valuation ($20 a share). It’s now worth $2.2 billion, or around $3.67 a share, a decrease of more than 80%. And Zynga, maker of social media games like FarmVille and Words With Friends, went public at $10 per share ($7 billion market cap) and today is trading at around $2.70, a decrease of more than 70%. Even Facebook, which was consistently profitable prior to its IPO, spent more than a year below its IPO price (it now trades at more than $133 per share, an increase of 250% from its $38 per share IPO price).

The arrogance of the tech world (I'm in it) is that we believe we are immune from the basic laws of economics. We are physicists who have created our own world in which we jump off a building and expect not to fall or, if we do fall, we expect someone else to catch us. Moreover, we are enabled by others (like bankers) who ought to know better that we are not worth more simply because we are tech people or "cloud people" or people who wear Steve Jobs smart-guy glasses.

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I have never heard a good argument as to why tech companies should be valued more than, say, a dry cleaner or a construction company. It is true that companies should be valued on growth and future profits, but let's look at the value of Snap as a case study. Roughly, to justify a value of $20 billion (that is the rough value they seem to be assigning themselves through their bankers), you are making a set of lofty assumptions. In one scenario, in trying to get to that value, they would need to grow for the next ten years (a normal investment horizon) at more than 50% every year with a net margin of 25% (which would be extremely high given that they are now losing money rapidly) at a discount rate of around 15%. Is this likely to be achieved as you compare them against, say, all companies over the entire investing history in the United States? I’m less offended by the fact they are going public than their idea of their own value. They are the guy who wants to eat 10 pounds of ice cream a day and, not only not gain weight, but also believes it is his right to transfer the calories to his sister.  Additionally, it sounds as if Snap might only be offering shares that are non-voting — the guy eats the ice cream, transfers the calories to his sister and then does not give her the ability to tell him to stop eating so much ice cream. There will always be some ninnies in the world — this is a base expectation. The problem is that the investing public has to pay attention and safeguard themselves against ninniehood.

There is a kind of mystique to tech companies that is getting more and more senseless as the expansionary economy grows. As we saw with Twitter, these companies are not immune from economics, even if they have a neat idea and are run by Stanford grads with supermodel girlfriends. In the end, investors who buy high don't always sell higher. Yes, even in California, one plus one equals two, eventually.

Brian Hamilton, the co-founder of Sageworks, holds two patents for his work in automating financial analysis and appears regularly on CNBC.

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