Are IPOs Good Investments? What to Learn From Reddit and Trump Stock Flops

IPOs tend to receive considerable media attention, which often results in novice investors believing they present the market's next golden opportunity. And with the number of IPOs (initial public offerings) slated for 2024 indicative of a revival, they're once again in the spotlight. But the actual value IPOs offer is often misunderstood, which has been underscored by the recent flops of Reddit and Trump Media & Technology Group.

An unprecedented 2,436 companies went public in 2021, but the following two years saw a historic drop-off. In 2022 and 2023, there were a record-low number of IPOs, and companies going public with valuations of $1 billion or more were at their lowest level since the Great Recession, according to Adam Parker of the Financial Times, who cited high interest rates as the principal culprit.

However, it isn't just the Federal Reserve's monetary policy that's limited the number of IPOs in the recent past. Overvaluation and underperformance have been growing concerns on Wall Street.

"Since 2020, the relative return of average IPO measured from its day one closing price has lagged behind its industry group by more than 20 percentage points after the first year," Parker wrote. He noted that more than 60% of the companies going public lag behind their industry averages by over 15% a year later.

So why, then, does the fervor over IPOs persist? In many cases, it can be attributed to lack of investor education.

Reddit and Trump Media as IPO case studies

Two companies that had IPOs this year took the internet by storm. Reddit (RDDT), a social news aggregate network with over 71 million daily users, debuted on March 22. Trump Media & Technology Group (DJT), which owns the former president's Truth Social platform and was brought public through an SPAC merger with Digital World Acquisition Corporation, followed on March 26.

Shares of RDDT, a company that hasn't posted a profit since its founding in 2005, gained over 7% in the first five days of trading. DJT found even more success out of the gate with shares climbing nearly 33% in its first two days of trading.

The merriment surrounding their debuts was short-lived, though. In the ensuing three weeks, Reddit's stock fell by more than 17%. Then, less than a week after its IPO, Trump Media disclosed that in 2023, it posted a net loss of $58 million last year on revenue of just $4.1 million, causing shares to plummet over 65% from its post-IPO high of $66.22 to $22.84 by April 16.

To illustrate those losses, an investor who purchased $1,000 worth of RDDT on its IPO day would have an investment worth roughly $830. And if that person invested $1,000 in DJT when it debuted, those shares would be worth just $350.

Nonetheless, the hype surrounding both IPOs has generated massive trading volume, with DJT reaching as high as 26 million trades in a single day and RDDT exceeding 44 million the day it debuted. These figures suggest that investors are overlooking fundamental flaws in both companies.

Between December 2022 and December 2023, Reddit's total debt increased by over 32% and its net cash flow was -$84.84 million, leaving it with annual earnings per share (EPS) of -$1.54 before going public. The consensus EPS forecast for the company's first-quarter earnings announcement on May 7, 2024: -$8.77. For context, a negative EPS indicates that a company is losing money, and when EPS drops, share prices tend to follow suit.

Meanwhile, despite its precipitous fall in price, Trump Media's stock has remained over a minimum of $17.50 in its first 30 days of trading, allowing former president Donald Trump to capitalize on a merger provision that entitles him to an additional 36 million shares — worth roughly $1.17 billion — bringing the total value of his stake in the company to around $3.7 billion.

In a letter to shareholders, accounting firm BF Borgers CPA PC, which serves as the company's auditor, said Trump Media's ongoing operating losses "raise substantial doubt about its ability to continue."

Are IPOs good investments?

According to financial services and consultancy firm Edelman Smithfield, 91% of investors are "likely" or "more likely" to invest in IPOs in 2024, meaning that many people are ignoring the writing on the wall.

IPOs experience an exceptional rate of failure, with studies finding as many as 80% of these companies experience insolvency over the long term. Among the companies that went public in 2023:

• Warrantee Inc. (WRNT) saw its shares drop by 88% since going public on July 28, 2023.
• Lucy Scientific Discovery (LSDI), which debuted Feb. 10, 2023, has seen its stock fall by more than 96%.
• Shares of EV technology company U Power Limited (UCAR) have fallen 99% since its IPO April 21, 2023.

Oftentimes, IPOs involve deeply flawed companies with uninspiring financial statements. But with the proliferation of often self-taught traders since 2020, many people are ignoring fundamental analysis, which aims to determine a stock's true market value by evaluating its financials, in favor of technical analysis, which aims to predict price trends based on stock chart analysis, in the hopes that the charts will dictate the opposite of what balance sheets and cash flow statements are telling them.

There are exceptions to the rule, of course. While the majority of IPOs' share prices are lower one year after going public, 20% buck that trend.

Companies like Birkenstock (BIRK) and ARM Holdings (ARM) — both of which debuted in 2023 — have experienced growth and share appreciation since being listed on exchanges. Shares of BIRK, the German shoe manufacturer, are up nearly 24% since going public on Oct. 13, 2023. ARM, bolstered by high demand for semiconductors, has seen its stock rise nearly 61% since it debuted on Sept. 15, 2023.

However, in those cases, the companies are legitimately thriving businesses. Birkenstock, whose sturdy leather sandals have global reach, was founded in 1774, is profitable, has produced positive free cash flow and is enjoying quarter-over-quarter EPS growth. ARM has also produced consecutive quarters of positive earnings driven by heightened microchip demand and an industry that, according to consultancy firm McKinsey & Co., is in the midst of a decade of growth that's expected to culminate in a trillion-dollar valuation by 2030.

For novice and passive investors, the main takeaways are that IPOs present elevated risk and that it's often unwise to gamble on trendy companies that grab headlines. Embracing proven and historically productive strategies — like dividend reinvestment, dollar-cost averaging and investing in index funds — will help you avoid the financial pitfalls of the likes of Reddit and Trump Media.

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