You Feel Lucky, Punk? Then Invest in Twitter IPO

The only reason to invest in an IPO is if you think the company will outdo the market's estimates.

Yesterday, Twitter tweeted the announcement that it was filing for an initial public offering. USA Today explores whether retail investors can get a piece of the action. So let's look at whether retail investors (or you lucky few with "most favored investor status" at a major financial institution) should put their money into Twitter.

The first way to look at it is to carefully examine Twitter's profit-making potential. Here's the catch: We have no idea of its profit-making potential. The IPO documents aren't yet public, but it doesn't seem likely that they currently have any profits. There are all sorts of theories about how they totally could make profits, but not so many theories about how they currently are.

Let me pause to say that I, too, think that Twitter is great. I'm on it all day, reading tweets and tweeting. (From @asymmetricinfo, if you, y'know, wanted to follow me, she mentioned ever so casually.) Twitter is by far my favorite social-media app, and there are a lot of people who seem to agree with me.

Who couldn't make a profit out of a super-popular Web service with hundreds of millions of users who check their feeds with an obsessive fervor usually reserved for rats in lab experiments involving levers and cocaine dispensers? But the fundamental error that people make about the Internet is to confuse that which is popular with that which is profitable. If they were the same thing, the ranks of tech billionaires would be dominated by people who take pictures of kittens and compose poems about Jesus.

In fact, Twitter might find monetizing its popularity hard. Facebook found it harder than people expected to monetize its popularity, even though they've got a lot more users and a lot more space to run ads. The magic of Twitter is that your ad can generate a viral storm that takes it to millions of people. The problem of Twitter is that your ad can easily get lost in thousands of other tweets.

Don't get me wrong: Twitter is a great marketing channel. The problem is, how does Twitter get in on the cash that flows from using that marketing channel? There are lots of celebrities being paid to tweet about products, lots of consultants being paid to run social-media operations and lots of companies using Twitter for outreach. But how many of those folks are paying Twitter?

Facebook dealt with this problem by designing algorithms that throttled back promotional content -- unless you paid Facebook to give your posts a boost. And maybe a similar strategy will work for Twitter. But Facebook had a lot more real estate to work with than Twitter does, and a much more heavily curated newsfeed. All Twitter has is your stream, and 140 characters. If they choke too much of that stream with promotional content, users will lose interest.

OK, but say you really think that Twitter has what it takes. They're going to be the Next Great Advertising Thing. You should buy, right?

Not so fast, mi amigo. You also have to contend with the Efficient Markets Hypothesis. As taught to me at the University of Chicago, it goes something like this: Data show that people "actively trading" (buying individual stocks) are more likely to underperform a broad market index like the S&P than to outperform it, once you account for the costs of trading and of researching all those stocks. So don't. Almost all of the academics I know who study markets for a living put their money in boring index funds, not exciting individual stocks. You probably should too, especially because you are probably not a professional who studies markets for a living.

Here's the slightly longer version: Imagine you're selling something valuable, like, say, an ownership stake in a rapidly growing Web concern. That stake will entitle the buyer to some small percentage of the firm's future cash flows, forever and ever. How will you set the price for this valuable asset?

Why, you'd probably want to project the firm's future cash flows, and then charge a price for each share equal to the value of those future cash flows, appropriately discounted for things like risk, and the fact that far-off profits are worth less than a dollar you have in your hand right now, here, today.

Which is to say that you can't make any money just buy buying into a rapidly growing company, because the price will be ... the expected value of buying into that company. In order for your investment to make money, the company has to perform better than expectations.

Oh, there are wrinkles to this -- IPO values are often set a bit lower than the value at which the stock is expected to trade. If you are an insider, this is a fine practice that insures a deep and liquid secondary market for the stock; if you are an outsider, it's outrageous self-dealing by rich people. Either way, this offers the possibility of making some "free money." But keep in mind that there are also risks, because you're committing to buy at a time when there is no market in the stock. Folks who invested in Google got a huge payoff. Folks who invested in Facebook and Groupon got heartburn. So it remains true that it probably doesn't make sense to invest in an IPO unless you think the company will outdo the market's estimates.

This is not impossible, of course, because we don't actually know how much money the company will make. The expected value is set by millions of people guessing. If your guess is more optimistic than theirs, and also correct, you will make money. But note that the odds of both of these things being true are not all that great. Better stick to using index funds for investing, and Twitter for complaining about "Breaking Bad."

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.