Financial journalists aren’t known for their attention to detail, but there’s one particular topic that they seem to universally get wrong: IPOs.
Tonight I witnessed yet another debacle of IPO anti-logic while watching Behind the Counter: Inside Chipotle. To illustrate Chipotle’s success, the episode brags:
The day Chipotle went public… the stock went wild, doubling in one day, the second-best restaurant IPO of all time.
Take a moment to think. If your company IPOs at 9am for $200 million and hits $400 million by the end of the day, does that mean your company’s prospects have magically doubled in one day? (Probably not.)
What it really means is that your investment bank underpriced your shares by 50%, giving away all that money to its clients and itself (on top of the hefty 5% fee they already charged you).
In fact, a strong IPO ‘pop’ says almost nothing about the strength of a company. Boston Market, the record holder for biggest restaurant IPO pop of all time, saw its shares rise 143% the day of its IPO, but filed for bankruptcy a mere five years later. The next biggest, Fresh Choice, rose 91% on its first day of trading, but also landed in bankruptcy court after just 11 years.
What so many financial journalists don’t communicate is that in a perfect world, IPOs would have no pop at all. Investment banks would peer into their crystal balls, divine the correct price, and sell the stock without any wild price swings. A flat IPO is the ideal IPO.
Of course, financial journalists aren’t stupid. So why are they so consistently wrong when praising IPO pops? The problem is that they pick the wrong counterfactual.
In any judgment of a thing’s goodness or badness, there must always be a counterfactual reference to compare against. If we say Chipotle’s IPO pop was good, that’s equivalent to saying that the IPO without a pop would have been worse.
Now in the case of IPOs, journalists consistently pick the wrong counterfactual reference. They think to themselves: given that the stock opened at $200 million, would Chipotle be happy about it rising to $400 million? And to be fair, the answer to that question would be yes, Chipotle undoubtably prefers a higher valuation to a lower valuation.
But let’s take a moment to view things from a second angle. Given that Chipotle stock ends the day at $400 million, would Chipotle be happy that in the morning they were paid only $200 million for it? Absolutely not: they got only half of what the stock ended up being worth!
And now we have finally arrived at the crux of the issue. Each time someone calls an IPO pop ‘good’ or ‘bad,’ they implicitly pick a counterfactual reference. In the end, the question of whether an IPO pop is ‘good’ or ‘bad’ boils down to which counterfactual reference you choose.
However, not all counterfactual references are made equal, and in this case, one is clearly better than the other. The better counterfactual reference is the second story, where the closing price is anchored and Chipotle is unhappy with its investment bank. The reason that the closing stock price makes a better anchor is that it represents the full consensus of the market, whereas the IPO price in the morning only reflects the opinion of a single participant, the investment bank. (Furthermore, the true job of the investment bank is not to predict what Chipotle is worth, but to predict what the market will think Chipotle is worth. By that logic, it is almost tautological that the market’s price is better than the investment bank’s price, because the market’s price is what the investment bank is trying to predict!)
If you remain unconvinced that big IPO pops are bad for companies, let’s perform some reductio ad absurdum and take things to the extreme. Suppose that in 2012, Facebook decides to eschew the traditional Wall Street investment banks and instead turns to the brand new investment bank Ted Sanders & Friends. After consulting his dowsing rods, Ted Sanders decides that Facebook is silly and worthless, and proceeds to sell all of Facebook to his Friends for $10. Ted’s Friends then immediately turn around and sell that $10 stake for $100 billion on NASDAQ. What are the odds that Facebook, which earned only $10 in the deal, will be happy about its record 1,000,000,000,000% IPO pop? I leave this as an exercise to the reader.
Given how unproductive huge IPO pops are to companies raising money, it’s bizarre how much journalists praise them. In almost every IPO news story, you’ll see journalists imply that a big IPO pop is something to be desired rather than avoided.
However, the point of this post is not to bash journalists for getting IPOs wrong. Journalists, like all of us, are a product of their environments, and so it’s worth asking what incentives and structures drive journalists to consistently misinterpret IPOs.
Unfortunately, I think the answer originates in journalism’s search for a simple narrative. If I tell you that Chipotle IPOed for $200 million, what would that mean to you? Is it a good number or a bad number? Did Chipotle win or did they lose? Without context, it’s hard to answer. It takes some additional work for both the journalist and the reader to establish a narrative. But if I tell you that Chipotle’s IPO stock rose 100%, now what might you say? “Chipotle goes up!” “Chipotle is desirable!” “Chipotle sizzles!” The narratives practically build themselves. It’s perfect for the lazy journalist and the lazy reader.
Sadly, the easiest narratives are often not the truest.