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Don't get caught in emotional hype of IPOs

Tuesday, March 3rd, 2015

Over the years clients have asked whether I'm going to buy this or that IPO, or the latest and greatest IPO that is being released.

My answer is always the same: We don't have enough financial information to make a good decision on buying a company that is new to the public markets. I also explain that the emotional hype behind the initial public offering often does not justify the stock price.

On Jan. 30, an initial public offering for Shake Shack (NYSE: SHAK) started about $25 per share. The stock climbed as high as $52.50 per share the same day.

The excitement about this company just amazed me because it really doesn't do anything extraordinary; it sells hamburgers, hot dogs and fries.

Now that numbers are starting to come out, it appears to be worse than I thought. Based on the mean calculation of seven analysts, the company is looking for earnings per share of 5 cents.

That’s right: 5 cents.

With the stock trading about $43 per share based on its 5-cent earnings, the company has a forward PE of 860 times the earnings. That reminds me of the tech boom-and-bust days. I also noticed that although the company does not have a lot of debt, it appears to have a problem with a current ratio of only 0.60 — any disruption in the business and it may not be able to pay its bills.

The company has a very high forward price ratio. If an investor looks at the price to tangible book value, there is not a great value there, either, as the company trades at 43 times tangible book value — far more expensive than the industry average of 17.2.

So while I'm sure some investors who may have been lucky enough to get in on the IPO price of $25 per share have done well, I know that the number of people who got shares at that level is very low. Many more invested in the stock after it began trading and the range of the stock in that short time has been a high of $52.50 and a low of $38.64.

So many investors, I'm sure, are now well underwater after paying $45 to $52 per share for this company that sells hamburgers. During all the hype I couldn’t understand why people didn't realize that the company had only 63 restaurants and that it expected to open only 10 restaurants per year.

Shake Shack also has many competitors, including Five GuysMcDonald's (NYSE: MCD) and In-N-Out Burger. I'm sure you could add to the list very easily, as well.

It is hard to make money in a crowded competitive field such as making hamburgers. Why this company even trades at $43 a share makes no sense to me. This company should be trading in the single digits and even that is a gift. Just think about its earnings growth going forward and its current earnings. If it increases 10 times the 2015 estimate of 5 cents and comes in at 50 cents in earnings per share, the stock would be a buy only at $6 per share, and that appears to be a long way off.

Two other IPOs that shot up like a rocket and have since dropped by a large amount would include GoPro (Nasdaq: GPRO) and Alibaba Group (NYSE: BABA). Why one would blindly invest in these IPOs based on emotions when you can invest in companies such as Apple (Nasdaq: AAPL), which trades at 14 times the earnings-per-share estimate for 2016, is beyond me.

Also, in the fourth quarter of 2014, Apple sold, on average, 34,000 iPhones every hour, 24 hours a day every day in the fourth quarter. While I will admit that at the current level Apple is slightly above my buy price, it is still a far better buy than these high-risk companies that come out as exciting IPOs.

Since I mentioned GoPro and Alibaba, I thought I should also give you their stock range and earnings-per-share estimates going forward. GoPro has an all-time high of $98.47, which was reached just a couple of months after the IPO. Today, the stock trades about $45 per share.

Looking out to December 2016, the earnings-per-share estimate based on the mean answer of analysts is $1.68 per share, which equals a forward-price-earnings multiple of 27 times earnings.

Alibaba is in the same boat with an all-time high of $120 per share and a current stock price that is almost 30 percent lower at $85 per share. For the year ending March 2016, the mean estimate on earnings is $2.87.

Based on the current stock price of $85 a share, this means investors are paying nearly 30 times the forward earnings, more than twice that of what an investor would currently pay for Apple.

I have been in the investment world for more than 30 years, some things have changed over time — actually, a lot of things have changed since I begin managing money — but one thing that has not changed is that IPOs are still very risky.

Do you have a question or a company you would like us to take a look at?
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