Snapchat slated to have the highest price-to-sales ratio of any major U.S. IPO
By Mark Hulbert, MarketWatch
Simple math is all you need to conclude that Snapchat’s upcoming IPO is an incredibly risky bet.
That’s because the company’s sales will have to grow at a blistering pace in order to support the price at which it is currently slated to come to market. Though anything is possible, you probably should go to Las Vegas rather than Wall Street if you want to place that kind of high-risk bet.
I base these comments on a simple valuation model that focuses on sales rather than earnings. That’s crucial for startups, since most of them—like Snapchat—have yet to produce any profit by the time they go public. Price-to-earnings ratios therefore are useless for valuing them.
Price-to-sales ratios, in contrast, speak volumes.
Snapchat parent Snap Inc. (SNAP) for example, will at IPO have a price-to-sales ratio (PSR) of 55.6, assuming it comes to market at the midpoint of the $20 to $25 billion range reported by The Wall Street Journal. That would be higher than any other major U.S. IPO in decades—and maybe ever. (I base this on data from Jay Ritter, a finance professor at the University of Florida and academia’s leading expert on the IPO market; included are all U.S. IPOs since 1980 that, when coming to market, had at least $200 million of sales in 2016 dollars.)
PSRs almost always decline as a company grows, however, and that’s the Achilles' heel of a high PSR. In order for its stock price to not fall along with its ratio, revenue must grow just as fast as the ratio falls.
How far does the typical company’s PSR fall over its first five years as a publicly traded company? Google’s (GOOG, GOOGL) for example, fell from 10.3 to 4.9; Facebook’s (FB) fell from 25.3 to 11.1. In fact, according to FactSet, the median internet company’s PSR on its fifth birthday was 2.8.
Regardless of which of these numbers we use, Snapchat’s sales will have to mushroom over the next five years. If we assume its ratio in five years will be equal to what Google (now Alphabet) had on its fifth birthday as a publicly traded company, Snapchat’s sales will have to grow more than 10-fold—just in order for its parent company’s stock price to stay even.
That works out to an annualized five-year revenue growth rate of 63% per year. To put that in context, consider that U.S. IPOs that came to market between 1996 and 2007 had average five-year revenue growth rates of 26% annualized. (This according to research conducted by Ritter and two colleagues.)
Of course, you wouldn’t bet on a company if you didn’t expect it to make money. So breaking even is nowhere good enough. That in effect means you have to bet that Snapchat’s sales will grow by even more than 10-fold over its first five years. A lot more.
For illustration’s sake, let’s assume that you require a 15% annualized profit in order to compensate you for the high risk of Snap stock (higher than the overall market’s historical rate of 10% annualized, in other words). If so, then its five-year revenue growth ratio will have to be 87% per year. In other words, the company will have to nearly double its revenue every year for five years in a row.
To put that in context, consider that Google’s five-year revenue growth rate after IPO was 57% annualized. Facebook’s was 47%.
To repeat, it’s not impossible for Snap to jump over these higher barriers. As Professor Ritter pointed out to me in an interview, in the “winner take all” internet economy, a successful company could very well live up to the growth expectations embedded in a high PSR.
But, by definition, there are far more losers than winners in a “winner take all” arena. How confident are you that Snap won’t be one of them?
Don’t like the numbers I’ve used in this analysis? Be my guest and play around with other assumptions about how much you expect the stock price to increase over the next five years and what its PSR will be then. No matter how you slice and dice it, however, you will find that Snap is an incredible long shot.
Courtesy of MarketWatch