How Google Mispriced Itself

An IPO researcher argues that Google left money on the table because it didn't divulge its growth outlook, not because it held a stock auction

by Jay Ritter

On July 26, 2004, Google (GOOG) announced plans to sell 28.3 million shares at between $108 and $135 apiece, hoping to raise at least $3 billion in one of the most heralded initial public offerings of stock ever. Rather than use Wall Street's venerable "bookbuilding" method, the company and its underwriters planned to employ an auction to price the IPO and allocate the shares to investors.

An auction, in theory at least, should deliver the highest possible price for the company while giving individual investors, rather than just the fund managers who dominate the bookbuilding approach, the opportunity to buy shares.

Unexpectedly, in the face of weak demand, Google was forced to scale back the size of the stock sale and lower the offering price. On Aug. 19, 2004, Google went public at $85 per share, selling just 22.5 million shares and raising just $1.9 billion. Adding insult to injury, the stock rose 18% on the first day of trading to close at $100.34. Because that quick $345 million gain went to investors rather than Google's pockets, some would suggest the auction failed to achieve its purpose of setting a price close to the value investors would be willing to award the stock on the open market.

Part of the reason that the offering raised less money than expected was simply bad luck: In the weeks leading up to the IPO, both the technology-laden NASDAQ market (NDAQ) and shares of Yahoo! (YHOO), Google's top rival, had been drifting downward, sending a chill through the IPO market.

But because Google used an auction, some critics have blamed Google's decision to spurn Wall Street's tried-and-true procedure of bookbuilding.

The Secrecy Initiative

In my opinion, the failure to raise as much money as the company expected had nothing to do with the choice of an auction. Instead, it had everything to do with management's decision to pursue a policy of secretiveness about Google's business.

Let me explain. But first, a disclosure: In 2002, long before Google's IPO, I did advise the company on the advantages and disadvantages of an auction. I was one of many advisers Google consulted, and I was not involved in any of the final decisions, nor did I have any financial stake in the outcome.

Now, imagine a successful young company whose profits per share grew 135% over the prior year. Outsiders are trying to figure out whether profits will continue to grow at that 135% rate for the next few years, in which case a price-to-earnings ratio of 120 might be justified, or accelerate to a growth rate of 190% per year, in which case a PE ratio of 200 might be justified.

If management thinks the more optimistic scenario is realistic, and they're about to sell shares in an IPO, then they have every incentive to disclose that information. Furthermore, if outside investors are skeptical about the reliability of this information, management has an incentive to agree to a "lockup" on selling their personal shares until after they report at least a couple of quarters worth of operating results. This means an executive will suffer the same market consequences as any investor if the company's actual performance fails to justify the pre-IPO forecast.

Revealing Forecasts

Normally, if management has positive information about the company's earnings prospects, these forecasts will be voluntarily revealed to institutional investors during the "road show" marketing campaign that precedes an IPO. So if management is not voluntarily revealing better prospects, it is perfectly rational for an investor to assume that there are no better prospects to reveal. Furthermore, when most young companies hold an IPO, the top managers usually don't sell any personal shares. In fact, they almost always agree to a lockup period of 180 days before they can sell shares.