Download now: How To Invest in the Coming Bitcoin Boom

So You Bought Snapchat...

Written by Briton Ryle
Posted March 8, 2017 at 7:12PM

The latest IPO of the next big thing — Snapchat — is not looking so good. True to form, the Wall Street investment banking machine and the financial media hypesters at CNBC whipped the crowd into enough of a frenzy that the stock popped nicely in its first two days of trading. 

The stock "went public" at $17 a share. But of course, it was never really available at $17. That's not how this works. Sure, big important clients at some investment banks might've gotten it at $17, but you and me? Yeah, right. Again, that's not how it works. Individual investors are third on the food chain, maybe fourth...

First there are the venture capitalist guys that buy into hot new companies in the early stages. Then there are the investment banks that come in with some investment capital in order to ensure a piece of the action when IPO day rolls around. Then there are the favored clients that get the cheap shares of the actual offering — which were $17 for SNAP. Then, after all those players get their piece, those shares hit the market. 

It's basically payola, all the way down to when the shares are actually available on the Nasdaq or New York Stock Exchange. Which means when you buy an IPO, you're paying the favored clientele their profit. You're paying the investment banks. And you're paying the venture capitalists. And you're paying the company insiders...

They are all selling — and you're buying. 

In this case, it probably won't help you to know that SNAP founder Evan Spiegel is now a 26-year-old who's worth over $5 billion. 

Now, maybe you bought SNAP, maybe you didn't. I warned my Wealth Advisory readers to stay away from it. It was obvious to me what was about to happen...

Wall Street: Fooling Some of the People ALL of the Time

So far, American businesses have struggled to resonate with this up-and-coming millennial generation. 

Starbucks has done it. McDonald's has not. Netflix is in there. Comcast is right out. Facebook is for "old" people like me, but Snapchat is a service that is almost exclusively used by the millennials. And so the potential for Snapchat to become an advertising platform to the coveted yet tough-to-crack millennial generation is compelling.

There was a Wall Street Journal article yesterday pointing out that the millennial generation really came out for the SNAP IPO. It makes sense — SNAP really is the first truly millennial stock to hit the market. And the millennials have really not shown much interest in investing to this point.

In one case, a young lady said it was her first "big" investment. She said she was taking a college class about investing and put an order in to buy SNAP up to $40 a share. 

A couple things: One, to her and other millennials who are sitting on some losses in SNAP, please do not judge investing on the SNAP IPO. There were some very simple warning signs about what was going to happen. I will share them in a minute...

And two, what the heck are they teaching at that college? 

Let's start with number two...

If you're gonna teach kids about investing, you have to start with a discussion about valuations and price. I can't say it enough: you simply have to know what something is worth before you can make an informed decision on a purchase.

Warren Buffett said price is what you pay, value is what you get. When Buffett buys a company, he's not thinking about what the stock of that company will do, whether it will go up and make him some money. He's thinking about what the company is actually worth. He does this by figuring out how long it will take him to pay off his purchase using only the company's earnings. 

So let's say a company is making $1 a year in earnings per share (EPS). And you can buy the whole company at $10 a share. It would take 10 years of earning $1 a share to pay off that purchase. This means the company has a price-to-earnings (P/E) ratio of 10. And a P/E ratio of 10 is attractive. 

If a company has a P/E ratio of 15, it basically means it would take 15 years to pay off the purchase. Not as good as 10, but still not bad. A P/E of 20 might be pushing it. Do you really want to wait around 20 years to pay off your purchase?

Of course, there are other factors that must be taken into account to get the full picture, like how fast sales and earnings are growing, whether there's room for improvement that would help the company earn more, and so on. But for a rough-and-ready version of how to value a company, this simple "buyout valuation" idea works. 

So, when the young lady was willing to pay up to $40 for a share of Snapchat, she was saying that she thought Snapchat as a company was worth about $46 billion. Her professor should be ashamed.

In the last 12 months, Snapchat did a little over $400 million in revenue. It lost more than that. We can ignore the earnings for now, since this is an emerging company. But that revenue number, $400 million, means she would be willing to pay 110 times revenue for Snapchat. 

In real estate, houses are often valued based on comps — that is, comparisons with similar houses in similar neighborhoods. Comparing stocks can work just as well to help you get a feel for what something is worth. Of course, there aren't many good comparisons for Snapchat. But even if you just look for other companies worth $40+ billion, you can learn a lot...

Ford is valued at $48 billion. FedEx is $51 billion. Northrop Grumman is $43 billion. 

It would take a lot of convincing for me to put Snapchat in with any of these...

Don't Blame Wall Street

It is a basic tenet of capitalism that the market decides the price of something. If people will pay it, then that's the price. It's no different with stocks. If you want to overpay for a stock, you're certainly welcome to...

You can't blame the founders of Snapchat for wanting to sell their company for as much as they can get. And you can't blame the venture capitalists for trying to get the most out of their investment. Venture capitalists get a bad rap. But they provide very important functions in terms of capital and mentoring. 

You can't blame investment banks for seeking to reward their big clients. Those SNAP shares at $17 are like a fruit basket at Christmas. 

No, when you pay too much for a company, there's only one person to blame: the one who clicked the "buy" button. And so you know, I've paid too much for companies before, and I'm sure I will again.

Until next time,

brit''s sig

Briton Ryle

follow basic@BritonRyle on Twitter

An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

Comments

Buffett's Envy: 50% Annual Returns, Guaranteed