No more rubbish about failing IPOs, please

The Twitter IPO is drawing a lot of interest. A link to earlier IPOs is easily made. But people who claim that the Facebook IPO was a failure, have no clue about investing or the rules of the stock market.

In this otherwise interesting post, the author writes: "Facebook floated at $104b (massively overvalued, it took 15mo to return to that level)".

This fails on several levels:

• Facebook went public and hence its IPO was a success. Trading or IT systems failing, is an entirely different matter.

• The share price going down directly after the first trades doesn't change that either. And its subsequent reversal couldn't make an IPO right.

• Why would Facebook be overvalued? Where are the DCF calculations to support this claim?

• Has the value increased over the last 15 months? Is Facebook not overvalued now, just because the share price is above the IPO level?

The market value doesn't equal the 'true' value. Nobody knows the 'true' value. 'True' value is a personal valuation and depends on personal assumptions in ones personal DCF model.

The stock market works in two different ways. First, there is the game only professional investors play:

1. Fully understand the business to make the best possible estimates for growth and margins. This is the hard part and it is entirely personal.
2. Translate this into a valuation, using a standard DCF model. This is the easy part. Excel does the job. The value you arrive at, is your true personal value.
3. Compare this to the market value. The assumption is that the market will in due course recognise that you have the best assumptions (see 1) and hence the best valuation (see 2). If your valuation is lower than the market value, you are a buyer of the stock. If it is higher, you are a seller.

Second, one must remember that the stock market is a second hand market. Immediately after the IPO (or a new share issue), stocks are bought and sold in a closed market system. Investors are looking for the greater fool to sell stock to or to buy stocks from. DCF-based valuation doesn't come into play in this game, possibly only in the longer term or as a long-term beacon signalling excessive over- or undervaluation. There are lots of methods to play this game, most notably quantitative analysis and technical analysis. This game is played by both professional and non-professional investors. Obviously, professionals bank on finding these greater fools among non-professional investors.

Finally, let me ask you this. You walk into a computer store and buy a EUR 1,000 laptop. What is the true value 5 minutes after you leave the store?

• The wrong answer is: a lot less, because second hand laptops cost much less than new ones. This is not the true value, but the market value.

• The right answer is: this is a personal matter and depends entirely on the cash flows you expect to be generating from using this laptop (DCF approach, as above). And thus, to the buyer the value of this laptop is probably a lot more than EUR 1,000. After all, his job depends on it.

Put differently, there is a big difference between market value and true value. And it is not just that the market value is real-time available, whereas true value is a personal thing. That's only the beginning.