A Quick Back of the Envelope Way to Determine if an IPO is Overvalued

Lots of chicanery took place in the IPO markets the past decade. Reason being: the private markets are way overvalued. The valuations enjoyed in the private markets aren’t the same as the public. As such, when hot IPOs come public, they’re often destined to fail, almost designed to.

Let’s take Shake Shack as an example. This is the preeminent fast food growth story in the country, especially now since CMG is in rebuild mode.

When SHAK came public, there was a lot of excitement around the shares. But the average layman had no idea how to value it — because, more or less, valuation is rarely if ever talked about on the dominant financial news channels.

Look at how they gunned the stock higher upon coming public.

$96 in April and by the time the ball dropped on New Years, the stock was at $30. For retail, this was a catastrophic decline, one that ruined an entire year’s returns for those who were overweight.

But all you had to do was look at the price/sales valuation against its peers to know, without question, the stock was in a dangerous price level to own. Wall Street is obsessed with peer comparisons. They always have been and always will be.

In 2016, SHAK was trading 8x sales. The hottest restaurant stock at the time was CMG — trading at 5x sales.

People gave up on SHAK, only because of the share price underperformance. But what they failed to acknowledge was that SHAK’s business was doing great. The only reason why the stock was flat to down was because it was ‘growing into’ its valuation. It was getting to a place where it could be owned, based off future expectations. This all materialized in the beginning of 2018 and now the stock is +50% for the year.

Now if you look at a price to sales chart, you see that WING is the outlier. SHAK is near the top, but no longer an outlier. The stock is up and the revenue growth has supported that increase in value. Providing the company can keep growing, I see no reason why it can’t continue higher. In theory, if SHAK grows revenues by 30% next year — the stock should increase by another ~30% — eventually heading back towards all time highs and more.

Don’t believe me? Look at the trajectory of DPZ over the years. Stocks increase in value due to either multiple expansion, which is a whole different topic, or market cap growth in line with revenue growth or earnings growth. In the case with mature companies who are past the hyper-growth phase, like DPZ, PE’s and FPE’s are how you’d measure the stock. Look at DPZ, +380% over the past 5 years, 300% greater than the SPY — yet the PE is virtually the same. The increase in price is supported by the increase in earnings. These earnings were created by technology and efficiencies established by management.

And the money shot.

For those waiting for the Exodus email detailing my process in finding momentum stocks, I will be sending it out tomorrow, as I enjoy my Father’s Day breakfast and coffee.

Get out there and enjoy the weather.

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