If you have to guess who the hardest person to contact is, would you pick Pope Francis, Barack Obama or George looney?

The answer is George Clooney because he doesn’t have a Twitter account.

Twitter, You Say?

Twitter is the 140 character messaging network that is redefining the way information virally travels from one corner of the world to the other. Twitter is the network that is used by the Who’s Who of the sports, entertainment, business and political world.

Unlike other social media, Twitter has become the network of choice for the followers and the followed, the news creators and the news consumers. In the 21st century, it is an equalizing force for communication. Twitter filed for an initial public offering (IPO) in October 2013, which has led to debate about the company’s valuation as well as the social media business in general.

Tweeting Public

An IPO is a company’s decision to sell its stock to outside investors for the first time. Through an IPO, a company goes from being a private company to a public one. The main reason a company goes public is to raise money from the public to finance its growth. It allows the company to expand its capital base through equity funding in exchange for shared public ownership of the firm. Members of the public want to join the IPO to be a part of the future growth prospects of the company.

Any individual shareholder who exceeds 5% ownership of outstanding (available for purchase) stock is considered a significant shareholder. Bill Gates, former CEO and founder of Microsoft, only owned between 19%-22% of the company at any given time.

Although an IPO seems like the beginning of a company’s journey, many steps must be completed leading up to this event for it to be a successful one. The last few years have seen many famous companies go public-Linkedin, Facebook, Yelp and most recently Twitter. Some of these companies have had successful IPOs and others have floundered for various reasons.

A Piece of the Pie

The first step in the IPO process is establishing the underwriters of the IPO-the bank or banks that will lead the initial public offering, information which will be filed with the Securities and Exchange Commission (SEC) through an S-1 form.

These banks will be involved in establishing the IPO price and creating demand for the shares in return for a percentage of capital raised through the offering. Twitter filed its S-1 form on October 3 of this year naming Goldman Sachs, J.P. Morgan and Morgan Stanley as the lead underwriters. The investment banks come in and perform due diligence on the client’s financial statements. In contrast to their public counterparts, private companies that are in the IPO stage do not have enough financial information to determine a valuation, so they are valued through a method called Comparable Transaction Approach. This method compares the company going IPO to other companies in the same industry that have gone public in the recent past as currently prevailing market conditions affect company valuations.

One of the difficulties of this process is creating the right universe of companies to include in the analysis, they might be in a different stage of company lifecycle, they might differ in size or risk factors, or the market might treat the current IPO differently than in the past-many of which contributed to the inflated valuation of Twitter.

The end goal of the pricing process is to come up with a price per share which is low enough to create demand in the market but high enough to raise the necessary capital for the company.

Taking the Show on the Road

Twitter has garnered a lot of attention since it filed for its IPO in early October. The initial price target set by Goldman Sachs was$17 to $20.

In this IPO, like all others, a road show was held to stir up demand. A road show takes place for several months leading up to the IPO where company management meets with potential institutional investors (large Banks and Pension Funds), Fund Managers and Investment Analysts to stir up demand for their stock offering. There was such a large demand for Twitter stock that Goldman Sachs bumped up the price from $23 to $25.

The final price on IPO day was finally set at $26/share which is the price the large investors got to buy at. By the time individual investors were able to buy Twitter the stock had jumped into the $40s. On its first day, Twitter reached as high as $50 before settling at $42, where it has been trading at in the subsequent days.

Lofty Valuations

The pricing of Twitter’s shares has created a debate about lofty valuations for internet technology firms going public. In 2012, the business community had a similar debate when Facebook went public. At the time, with $3.7B in sales and implied valuation of around $104B, Facebook had a revenue multiple of 28x, compared to Google of just 5.1x. Now Twitter has come out with an astronomical 33x. Based on its revenue projections, whether they will meet the revenue target of $1.2B in 2014 up from $600M in 2013 remains to be seen.

It has been a long time since a company going IPO has created such excitement. An increase in pricing from $17 to $26 and subsequently jumping into the $40s has largely been attributed to investors chasing a popular company rather than good financials.

Warren Buffet aptly called it “emotional exuberance” at play and not substantiated by the business. In terms of timing, Twitter has entered the market at a much earlier stage in its life cycle than Facebook did. Supporters are optimistic about Twitter’s potential triple digit growth prospects and are throwing Facebook’s tapered growth and poor post- IPO performance in the cynics’ faces. Is investing in Twitter a smart move or purely emotions at play-the world is watching intently.

Rahul Varshneya graduated from the Leavey School of Business at Santa Clara University with a degree in finance and is working in the technology industry as a financial analyst. He is currently enrolled in the chartered financial analyst (CFA) program.

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