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28
Jul 04
Wed

Google IPO Pricing

Jason Kottke mentions that the per share price of the Google float is largely irrelevant. He emphasises the more important question is whether the valuation of the company is accurate because the market capitalisation of a company is meant to be a representation of that company’s worth. However, he neglects to account for other factors that should be considered in purchasing stocks. One of the other major considerations is liquidity, and the absolute price of a stock is connected to this. The lower-priced a share is, the easier it is to offload and the more liquid it tends to be. There’s no point in having oodles of shares you can’t get rid of in a hurry; look at Berkshire Hathaway, for example. Secondly, there are adverse psychological factors involved when looking at a high stock price (especially for the individual investor) which further impact on liquidity. That’s why companies do stock splits: the market is not completely efficient, and investors are not all rational.

For those wanting to make a quick buck, the issue is predicting what market sentiment is, as much as it is about valuing a company accurately. This is because unless you are a huge institutional investor, everyone else in the market is determining where the price for a stock heads, and market sentiment reacts irrationally, especially in a weakly efficient market. The very psychological factors Kottke points out as silly are yet very relevant.

Splitting stocks may also carry connotations that a company is doing a roaring trade (Microsoft has had numerous splits). So, although mathematically speaking, a split will double share holdings and exactly halve the price, the funny thing is after a stock split the price may rise a little due to these connotations.

This post has 7 comments

1.  Bonhomme de Neige

The lower-priced a share is, the easier it is to offload and the more liquid it tends to be. There’s no point in having oodles of shares you can’t get rid of in a hurry; look at Berkshire Hathaway, for example.

Bollocks. The only time you might have concerns about quicly offloading the share is if you believe it to be overvalued, and want to get rid of it as soon as the market adjusts and the price starts to fall. But in this case, a much better startegy is to simply not buy it (or, sell futures ;p).

Berkshire Hathaway, which you cite as an example to support your claim, is actually a good example of why it’s not true. Look at that yahoo page you linked – average traded volume: 227 shares per quarter! That’s $19,737,650 worth of Berkshire Hathaway shares traded every quarter. That’s not illiquid, that’s not even thinly traded.

As for high stock prices, there is a psychological effect, but it’s the opposite of what you imply. A high share price is associated with very successful business by the company, which makes it a better investment target. Of course, this is a fallacy – high share price doesn’t imply good trading. Steadily and consistently increasing (historically) share price is the real indicator.

For those wanting to make a quick buck, the issue is predicting what market sentiment is, as much as it is about valuing a company accurately.

Wrong again, firstly in the assumption that most of those investing in google are out for a quick buck. I would say the vast majority would be after a long term investment.

But the more importany mistake is failing to realise the connection between accurate valuation and market sentiment – to make a quick buck you have to predict correctly whether the share price will rise or fall. Bubbles aside (there have been many bubbles, starting with the Tulip bubble in Holland in the 1600s, well before the noamous dotcom one), usually an undervalued stock price will rise, and an overvalued one will fall. If you think the stock price will rise, buy call options (or futures if you don’t mind the prospect of jumping off a skyscraper if you turn out to be wrong). If you think it will fall, buy put options (or sell futures, as above).

It remains to know whether a company is over- or undervalued by the market to predict the movement. Accurately valuing a company like Google is impossible, even for Google themselves. That’s why they chose an auction based model to let the market do most of the valuation for them.

Hence, someone after a (reliable) quick buck would do well to stay away from Google shares – any speculation without an accurate valuation of the company is just gambling (although the casino probably has worse odds).

As for stock splitting, it’s just as often used to dilute shares to protect (partially) against a hostile takeover (which it can do with correct timing, just like bonus issues or any other kind of share dilution tactics) as any other reason … which would mean the company is in _bad_ shape.

2.  Stu

I disagree. You say $20m of BRKa shares are traded a quarter. Total market capitalisation is $134.3bn. Compare this to MSFT shares, which had almost 70 million shares traded of it over the last quarter (roughly $2bn). Microsoft’s market cap is $309bn. Comparatively speaking, Microsoft trades, as a proportion of its market cap, around 43 times the amount of Berkshire over the same period.

Furthermore, the bid/ask spread is another indicator of liquidity, and with high-priced stocks, very large bid/ask spreads can result. BRKa is a case in point: its spreads can reach thousands of dollars.

If your rationale for stock splitting holds true (high prices psychologically imply strong companies, and splititng is also used to dilute shares to prevent takeovers), then why would a successful company split its stocks at all? On the contrary, a stock split normally means a company is going well. They are normally done for the psychological and liquidity reasons I’ve mentioned.

Thirdly, I never assumed that most people investing (in Google or otherwise) are out for a quick buck. I only said if your rationale was for making a quick buck then X (what I wrote) would be the case.

I agree that valuing a company like Google is extremely difficult. For traditional IPOs, it is often quite easy to make a quick buck. Underwriters would price the stock at a discounted issue price. The stock would open on the market and immediately rise (due to it being undervalued), thus netting float investors (normally institutional) a nice profit and making them feel happy with the underwriters. IPO investors out for a quick buck in this way are called stags. Google is trying to circumvent this by auctioning off its shares and trying to gauge a market price, but even this method has its weaknesses.

Valuing a company is extremely subjective. There are a lot of methodologies around (market capitalisation multiples, DCF, etc) that exist for it, but they are all underpinned by a series of assumptions the model-maker builds in to the model. So, the stockmarket value of a company is rarely an accurate representation of a company’s actual value, but what the market perceives to be an actual value (this is a greatly simplified explanation and there are other factors at play, of course). A company can only be judged to be “undervalued” or “overvalued” according to a financial analyst’s model, and different analysts have different models (that’s why you get analysts disagreeing on whether a stock should be bought/sold/held, apart from those analysts receiving “benefits” for releasing buy recommendations for certain companies).

3.  Stu

Additional note: I realise that the Berkshire/Microsoft comparison is unfair because the two companies are from different industries, but you’ll probably find that even within the US insurance industry, Berkshire Hathaway’s liquidity is actually quite low (about 0.015% of total market cap per quarter).

4.  Bonhomme de Neige

OK, for a start, Berkshire Hathaway is not an insurance company, so comparing it to the insurance industry is not more valid than comparing to MS. Berkshire Hathaway is essentially glorified a fund manager. And an extremely good one at that. That’s why noone wants to sell their shares ;p

Secondly, MS shares (by your figures) really do trade a lot. That doesn’t make BRKa illiquid, just less liquid than MSFT.

Bid/ask spread is typically measured as a % of share price … now I’m too lazy to compare that metric for BRKa and MSFT or something else, but I suspect it won’t be that different.

A company that’s in good shape, but doesn’t want to pay out dividends to investors (you usually can’t get away with that for too long, BRKa excepted), will split stocks. This way investors are happy (they get their bonus issue and feel like they’ve got something), but the company still keeps all its cash, which is what it cares about. Having $1bn of equity funding, from a company POV, is the same, regardless of whether that’s 100,000 shares or 100 million. I’m afraid your theory doesn’t hold water, since it’s not disadvantageous for a company to have less liquid stock. Thinly traded stock, yes, but there’s no way you’ll convince anyone with a clue that $20m/qtr is thinly traded.

Also I would think that if you _did_ have “oddles” of BRKa stock and you _wanted_ to get rid of it, you’d have no trouble finding willing buyers.

The most likely reason BRKa shares are not traded as much is that noone wants to sell them (why would you? They’ve been doing better than pretty much every other fund manager put together for 50 years), and that shareholders are actively discouraged from selling them. Read one of their annual reports and you’ll see what I mean.

The lower-priced a share is, the easier it is to offload and the more liquid it tends to be.

And that’s still as bollocks as it was the last time I posted a comment – good luck selling $1m worth of Interplay shares (they’re about as low-priced as shares get – http://finance.yahoo.com/q?s=iply.ob&d=t). By your measure of liquidity, their avg. traded volume per quarter is 0.16% of market cap., more than ten times higher than BRKa. Would you call them more liquid though? I think not. Why? You could offload $1m of BRKa a lot more easily than $1m of IPLY.

5.  Stu

Actually, Berkshire Hathaway is a holding company running a whole stack of subsidiaries (which themselves cover a large range of industries). Berkshire’s main business activities, however, are in insurance: property and casualty lines (whatever they are), and reinsurance.

I never said anything about illiquidity, only relative liquidity. (How would you measure illiquidity anyway? You’d need some arbitrary benchmark).

Also I would think that if you _did_ have “oddles” of BRKa stock and you _wanted_ to get rid of it, you’d have no trouble finding willing buyers.

Not that easy, if you’re talking about a lot of stocks (especially if you are doing a sizeable percentage of the total volume traded for the quarter – which, for BRKa doesn’t required very many stocks). If you sell too much stock you will make the market respond and the share price move before you can get rid of it all.

You could offload $1m of BRKa a lot more easily than $1m of IPLY.

Unlikely, for the reasons above (and assuming IPLY had a comparable market cap). Furthermore, it is easier to offload a portion of your $1m portfolio for IPLY than BRKa, which comes in $80k bundles. Of course the IPLY comparison is bunk as well, because the whole company’s market cap is pitiful $3.75m, so $1m would be owning more than a quarter of stock available on the stockmarket. (On the other hand, if you owned 0.1% of IPLY and 0.1% of BRKa, it would, ceteris paribus, be easier to sell your IPLY stocks.) Besides, liquidity is only one factor in assessing whether to invest. As with everything, context is important. The market was very “liquid” after 9/11 in terms of sheer volume traded, but that was because there was a mad selling spree which caused the prices of many stocks to gap downwards. Just because BRKa is relatively illiquid doesn’t mean it’s a bad stock. But over two identically priced stocks from similar sized companies that are performing just as well as each other, except for volume of shares traded, I would take the more liquid one.

Now, the reason why BRKa has never split is because it is trying to collect high-quality, “rational” investors:

“One of our goals is to have Berkshire Hathaway stock sell at a price rationally related to its intrinsic business value. (But note “rationally related”, not “identical”: if well-regarded companies are generally selling in the market at large discounts from value, Berkshire might well be priced similarly.) The key to a rational stock price is rational shareholders, both current and prospective.

“If the holders of a companies stock and/or the prospective buyers attracted to it are prone to make irrational or emotion- based decisions, some pretty silly stock prices are going to appear periodically. Manic-depressive personalities produce manic-depressive valuations. Such aberrations may help us in buying and selling the stocks of other companies. But we think it is in both your interest and ours to minimize their occurrence in the market for Berkshire.

“To obtain only high quality shareholders is no cinch … anyone can buy any stock. Entering members of a shareholder “club” cannot be screened for intellectual capacity, emotional stability, moral sensitivity or acceptable dress. Shareholder eugenics, therefore, might appear to be a hopeless undertaking. …

“Were we to split the stock or take other actions focusing on stock price rather than business value, we would attract an entering class of buyers inferior to the exiting class of sellers. At $1300, there are very few investors who can’t afford a Berkshire share. Would a potential one-share purchaser be better off if we split 100 for 1 so he could buy 100 shares? Those who think so and who would buy the stock because of the split or in anticipation of one would definitely downgrade the quality of our present shareholder group. (Could we really improve our shareholder group by trading some of our present clear-thinking members for impressionable new ones who, preferring paper to value, feel wealthier with nine $10 bills than with one $100 bill?) People who buy for non-value reasons are likely to sell for non-value reasons. Their presence in the picture will accentuate erratic price swings unrelated to underlying business developments.”

And that shows why things such as splits affect things such as liquidity – because investors are irrational.

6.  Bonhomme de Neige

But over two identically priced stocks from similar sized companies that are performing just as well as each other, except for volume of shares traded, I would take the more liquid one.



And that shows why things such as splits affect things such as liquidity – because investors are irrational.

Yep. ;p

Berkshire’s main business activities, however, are in insurance: property and casualty lines (whatever they are), and reinsurance.

It’s too late at night/early in the morning for me to check on those facts … but Berkshire isn’t an insurance company because it doesn’t manage the insurance subsidiaries it owns. It allows all of its subsidiaries to be run by their own managers (in fact, they never buy companies that don’t come with competent management, read the buying strategy in the Buffett’s annual reports…). A “holding company” is a glorified fund manager.

Casualty and property lines means property (building) insurance and mortality/disability insurance. Also I would be very surprised if they owned any “serious” reinsurers.

7.  Stu

And years later, vindication:

http://www.thestreet.com/story/10667234/1/best-in-class-berkshire-hathaway.html

“This, of course, all changed last week, when Berkshire Hathaway’s B shares completed a 50-to-1 stock split.

“Granted, five days of trading history with the new Berkshire B shares doesn’t provide much of a window onto long-term return potential. Average daily trading volume in the Berkshire Hathaway B shares has soared though, from 41,000 shares traded to as high as 6.6 million shares traded — and that was just on Monday. In the past five days, approximately 50 million Berkshire Hathaway shares have been traded.

“Consider this: the 50 million Berkshire Hathaway shares traded over the past five days represent what would have previously amounted to almost three-and-a-half years’ worth of trading volume for the Berkshire Hathaway B shares.

“It’s not hard to understand why there was such interest in Berkshire Hathaway after the stock split. The difference between a $3,400 share and a $70 share means the market’s most revered investment company can be purchased for a similar price to a few mail-order grass-fed Omaha steaks.”

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