How Google Mispriced Itself

(page 2 of 2)

During Google's road show, management refused to divulge any earnings forecasts to institutional investors, pointing out that the prospectus clearly stated "we do not plan to give earnings guidance." Adding to the uncertainty about Google's growth prospects were two discouraging signals from top executives: Some were selling personal shares in the IPO itself, and management was agreeing to lockups of only 90 days after the IPO before they could sell more personal holdings.

In response to these actions, institutional investors decided not to grant Google the benefit of the doubt: They did not award the company a price reflecting a PE ratio of 200. Instead, they went with the more "conservative" PE suggested by the historic operating data disclosed in the IPO prospectus. With fully diluted earnings per share (EPS) in the 12 months before going public at 72¢ per share, the offer price of $85 still reflected a PE ratio of 118.

And so, by not tipping off institutional investors to how fast earnings were expected to grow, and by allowing top managers to sell personal shares from the outset, Google found itself with a lower IPO price than it might have.

An Unconventional Company

This predicament had nothing to do with the use of an auction rather than bookbuilding. Instead, it had everything to do with the prospectus' declaration that "Google is not a conventional company."

The goal of getting the highest offer price in the IPO conflicted with the goal of opening the process to individual investors, treating them as equals to the professional money that controls the bookbuilding approach. Unlike most companies, Google's management gave a higher priority to the second goal.

In the end, only those who were willing to give the company the benefit of the doubt were richly rewarded when Google subsequently began reporting its quarterly EPS figures.

Notably, Google's refusal to clarify its prospects also led to gyrations in its stock price once it started to trade as investors puzzled over the company's true worth. On the first day of trading, the stock price jumped by 18%. In the following weeks, there were intraday price swings of 8% from low to high on several occasions. On Oct. 22, 2004, the day after Google announced its first post-IPO EPS numbers, the stock jumped by 14% after fluctuating by 10% within the day.

On all of these days, the market was having a great deal of difficulty agreeing on what the appropriate value of Google should be. Given all this market disagreement after the IPO, it's not very surprising that the auction wasn't able to perfectly forecast the price one day in advance. There is no reason to think bookbuilding would have led to a more accurate forecast.

A "Hot IPO" Scenario

No, Google's IPO did not go as smoothly as the company hoped. Many pundits have blamed this on the use of an auction. In my view, the key feature of Google's IPO was not the auction, but the unwillingness to divulge information to institutional investors that was not contained in the prospectus. These institutions were left in the dark regarding how rapidly the company's profits were growing. They only discovered the truth, and bid up the stock price, when the rest of us did—after Google announced its quarterly earnings.

Most of the time, whether a company uses an auction or bookbuilding for its IPO makes little difference. Some of the time, however, it makes a big difference.

The scenario in which it matters is when a company is lucky enough to discover that its IPO is "hot," with investors willing to pay more for the shares than had been anticipated. With an auction, a company can react by setting an offer price close to what investors are willing to pay. With the bookbuilding method, by the time a company discovers there is strong demand, it has little bargaining power if the investment bankers don't want to raise the offering price. In Google's case, the weak demand for its shares made this a moot point.

Jay Ritter is the Cordell Professor of finance at the University of Florida. Widely recognized as one of the world's leading academic experts on initial public offerings, Ritter has been analyzing IPOs for more than 25 years.