How to Misprice Your IPO

It's clear a year later that Google's shares were sold way too cheaply.
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It's hard to remember, but a year ago there were actually some Wall Street wags who were predicting that

Google's

(GOOG) - Get Report

initial public offering would be a dud.

The investment community's unease with the Internet search engine's unusual method for selling shares and the poor environment for IPOs forced the folks at Google to scale back their ambitions dramatically. The IPO eventually priced one year ago today at $85, a far cry from the $135 a share Google's founders originally had hoped to get.

Doom-and-gloom predictions for the stock abounded as trading began on Aug. 19, 2004. To put it mildly, the pessimism has proven unfounded.

Since their debut, shares of Google have been a runaway hit, rising 18% on the first day of trading and eventually more than tripling in price. On Thursday, shares of Google were trading around $278.

Google has become such a Wall Street darling that the company has decided to go back to the well. The day before the anniversary of its IPO, the company filed a registration statement with the

Securities and Exchange Commission

to sell 14.2 million shares in a bid to raise an additional $4 billion from investors. That's a little more than twice as much cash as Google raised a year ago.

Investors didn't seem too disturbed by the potential dilutive impact of so many new shares coming into the market. In Thursday trading, shares of Google were off just 2.3% after the announcement.

The spectacular run in Google, of course, raises the question of whether founders Sergey Brin and Larry Page should have stuck to their guns and pushed harder for the $135 a share IPO price.

In hindsight, it's easy to say they should have, even if you doubt the stock should be trading at a price that's 38 times next year's estimated earnings (after all, the $85 IPO price is only about 11 times the current 2006 estimate). But the truth is, Brin and Page have no one to blame but themselves for the relative lowball pricing of Google's IPO, which ended up leaving more than $1 billion on the table.

In reality, it wasn't so much Google's insistence on selling its IPO through a Dutch auction that hurt the pricing, but management's refusal to play ball with Wall Street investors during the roadshow last summer. Investors were particularly turned off by the company's reluctance to offer any guidance about future earnings.

"If you want a case study on how to tick off institutional investors during a roadshow, look at Google," says Jay Ritter, a professor of finance at the University of Florida who specializes in studying IPOs. "Google's refusal to divulge any information created a situation where investors weren't willing to give the company the benefit of the doubt.''

In the absence of information, investors tend to fear the worst. That's especially the case with a company that's going public and has a short operating history, even one with a product as well-known and well-respected as Google's search engine.

The investor unease about Google's prospects didn't play out well in the Dutch auction, in which investor demand -- not the investment banks underwriting the deal -- determined the price. The irony is, if Google's top brass had been a bit more open with Wall Street, they would've gotten a lot more money.

"If they had been more forthright about their business, they might have got a higher valuation,'' says David Menlow, president of IPO Financial Network, a new stock-offering research firm. "Their egos got in the way and hurt the price.''

Still, everyone loves an IPO pop, and you can argue that Google's lead bankers,

Credit Suisse First Boston

(CSR)

and

Morgan Stanley

(MWD)

, did Wall Street a big favor by setting the IPO price at $85, down from the $108 a share most had expected. The downward push virtually guaranteed Google a decent first-day pop and got everyone in the business press writing glowing stories.

Just imagine what would have happened if the shares had traded lower that first day. Google's stock no doubt would have recovered, but it's arguable whether the shares would have taken off the way they eventually did.

Menlow is not a big fan of the Dutch auction process and says it didn't serve Google particularly well. He says the problem with a Dutch auction is that investors don't have a good measuring stick for determining a company's value, especially when the company is playing things close to the vest.

Maybe that explains why Google has scrapped the Dutch auction idea and is going the more traditional Wall Street underwriting route in its secondary offering.