Snapchat’s Absurd Valuation Illustrates The Dangers Of Shorting Overvalued Companies

On March 2nd, Snapchat (SNAP) had its initial public offering (IPO) of shares.  Raising $3.4 billion by selling shares for $17, the shares quickly traded higher, closing at $24.48.  Trading $26.56 at the time this article was written, the shares reached an intraday high of $29.44 the morning of March 3rd.

As Zerohedge and MarketWatch covered, nearly all institutions have put a price target far below the current price level, finding the stock to be far overvalued:

In the past day since Snap’s SNAP, +12.07%  market debut, there have been at least six coverage initiations from brokerages on Wall Street. Morningstar initiated coverage with a $15 fair value on the stock, Pivotal Research initiated with a selling rating and $10 target, Instinet initiated with a reduce rating and a $16 rating, Atlantic Equities initiated with a hold rating and $14 target, Aegis Capital initiated with a $22 target and SIG Susquehanna initiated with a neutral rating and $22 target.

Clearly, the market doesn’t agree with the analysts’ initial opinion.  That doesn’t mean they won’t end up being right, but the average investor looking to short SNAP to make a quick buck should heed the history of tech company IPOs before they get involved.

SNAP is just one of a long line of tech companies that have IPO’d to analysts suggesting they were overvalued, only to have the shares beat all expectations.  Google (GOOG) was initially lauded as a ridiculous valuation for a search engine, and we all know how that turned out.  Alibaba (BABA) was also regarded as overvalued by many analysts; it soared above its $68 IPO price to close at $92.70 on its first trading day, peaking over $115.  Eventually, it fell below the IPO price, reaching a low of $59.24… but it has since rebounded and is trading $103 as of this article’s publication.

Of course, it makes more sense to compare SNAP to social media giants.  Facebook (FB) originally IPO’d for $38 per share.  It rose to a peak of over $42 on its first trading day, before closing just above the IPO price, at $38.23.  It hit its all-time intraday low below $18, less than half the IPO price just a few months after it was first publicly traded… and has been on a one-ray ride higher ever since, now trading $137 as of this article’s publication.

Twitter (TWTR) is another pertinent social media giant, but with a completely mirrored path.  TWTR IPO’d for $26, and closed on its first trading day at $44.94.  It reached an all-time high of over $74 before it finally tumbled to $30… then back above $50… then back below $37… then back above $50… until it finally began to gradually creep its way lower, and is currently trading for $15.71.

So, how does any of this relate to SNAP?  The reality is… it doesn’t.  SNAP is its own animal, and will behave however the market dictates.  Sometimes that is far out of line with its fundamentals.  For instance, the price is up today on news that Comcast invested $500 million in the IPO.  A government ruling favorable for tech could drag the whole sector up.  Or the price could be buoyed by a stock market that is simply trending higher.  A rising tide… lifts all boats.

With SNAP currently trading $26.56, you have to ask yourself what you really stand to gain out of shorting the company.  Yes, the business model might be awful, but it would take some grotesque mismanagement for the company to end up completely worthless.  At a certain point, it will become a takeover target, whether that price is $5, $10, or even higher, if someone is willing to pay enough.

So if you say the hypothetical floor is $10, you are risking whatever the ceiling is to make $16.56.  Take a look at the price action of the previous tech giants… did you have any idea what their ceiling was?  Shorting is not like buying – you need to be prepared to risk far more than your investment capital.  The lowest the stock can go is zero, but who knows what ceiling it will hit before it takes a tumble?

In between now and then, will you have the capital to stay in your position?  Will the stock become hard to borrow and force you to be bought in on your short?  Will the company change management and all of a sudden become a winner?  Or will another firm pay some even more ridiculously higher sum than their current valuation?

The only thing that is certain regarding shorting SNAP, is the risk/reward profile is an extreme unknown.  The only thing that is known right now, is that you can’t short it anyway – shares aren’t available for loan, and the market is closed for the weekend.  So you have a lot of time to decide if you think it is worth it to take a shot at shorting it.

Even if you think “Snapchat sucks,” don’t let that be the only factor in your decision to short the stock.