Apple, Netflix Make Case for Staying Private

How the stock market routinely misprices companies.

April 27, 2013— -- As I look at Wall Street headlines – namely, those having to do with Apple Inc.'s (AAPL) weak share performance and Netflix Inc.'s (NFLX) resurgence – I better understand why so many owners and stakeholders of privately held companies aren't jumping into the IPO line and some publicly traded firms are jumping out. Private owners, already dealing with a lot of uncertainty as they manage businesses in this economy, have a lot to lose in the market's volatile pricing, and many are finding insufficient motivation to overhaul their current setup in favor of an IPO. Out of the 27 million businesses in America, nearly all are already privately held, and they drive the lion's share of economic growth and jobs. There are excellent reasons for this.

The performance of these two high profile companies makes a case for staying private. Looking at the price of these two companies, it's hard to fathom that there is efficient pricing in the public markets, most certainly in the short run, which is sometimes quite important to owners and founders. Let's call this the Applix effect.

Before diving into the specifics, let me address a few theoretical issues. Advocates of the public markets assert that, while markets may not always act rationally in the short run, they tend to act rationally over the long run. I will concede this upfront, even though the definitions of "long run" have very important implications. Another argument for public markets is that, while a specific company may or may not be priced well, companies tend to be well priced as a group or in buckets. For example, let's say that Company A is overpriced but Company B is underpriced. If we make a bucket containing both companies A and B, that grouping might be pretty fairly priced. Despite the limited theoretical underpinnings to this line of thinking, I'll also accept this as well for the sake of argument.

However, in my view, market theory does not help a specific company, entrepreneur or group of founders in a decision to go public. As an individual running Company C, do you really care that over five years your valuation will be right or that, when mixed into a stew of other companies, the stew will be right? Of course not. Rather, you are rightfully very interested in how your specific company is priced and really only interested in that. You are most definitely also interested in the price if it is tied to your liquidity or wealth. Sure, public markets may be efficient on average. However, this should not allay the very real fears of specific companies. Ninety-five percent of a classroom might be getting the grades they deserve, but that's little comfort to the two students whom the teacher fails because he doesn't like them.

The performance of Apple and Netflix over the last several years demonstrates that specific companies should be cautious about going public. Let's look at the numbers.

Apple is the most profitable technology company in the world, and trails only two banks in China and a handful of energy or oil companies on Fortune's Global 500 list of most profitable companies. With a whopping net profit margin of nearly 24 percent and an almost incredible yearly sales growth rate of 19 percent, the stock price has plummeted by nearly one third since April 16, 2012. Shares that were $580 a year ago are now $406[1]. Based upon true economic performance, does this make any sense?

You might say two things are behind this. First, you might say shares were overvalued a year ago. Maybe, but applying some rough but solid benchmarks, I disagree. Apple traded at roughly 13 times earnings and almost 4 times sales last year. Now, Apple shares are less than 10 times earnings and 2.3 times sales. Remember: Facebook's sales multiple was 25 when it went public. Facebook still trades at 12 times sales and more than 1,000 times profits today. Another high profile technology company, Oracle, trades at 4 times sales and about 14 times profits. Second, you might say Apple's share price was correctly adjusted for technology changes in the market and missteps, such as problems with Apple's maps. But any market leader will have new competitors and most companies and people make mistakes, even large ones.

Now, look at the wild ride of Netflix. Twenty-four months ago, Netflix was at about $235 a share. The stock plummeted to $64 by November 2011 as investors punished the company's valuation for a service price increase that pushed users to streaming services. The stock dropped by 73 percent in the space of seven months. Over the last year, the stock has skyrocketed up to $216.[2] Let's look at their financial performance during this time. Sales grew 29.5 percent and 48.2 percent in 2010 and 2011, respectively. Company profits were growing by around 40 percent each year. Sales in 2012 were $3.6 billion, up 13 percent from 2011. Good growth, and a strong earnings report in April, but does it justify a tripling of share prices since late 2011? Of course not. Going forward, for the sake of shareholders, I hope their CEO never jaywalks in the future.

Companies don't go public in a group. They make individual decisions and their value – not the value of the market, per se -- is most important to them. Given the uncertainty of short-run pricing, can it be a surprise that the number of public companies has dwindled from more than 8,000 to 4,916 since 1997? (This does not even account for the substantial amount of administration and regulation companies are subject to when they are public). Most business owners who start their own companies do so because they're convinced they can do it better – build a better product, offer a better service, operate a company more efficiently – than the competition. They expect strong performance to be rewarded and weak performance to be punished in an equitable way.

The prospect of seeing their company's net worth or shareholder value go down as Apple's has gone would be unsettling for management, employees, lenders and other business partners. Who needs that kind of uncertainty? I don't see many hands being raised.

Mary Ellen Biery, Research Specialist at Sageworks, contributed to this article.

Brian Hamilton is the chairman of Sageworks. Brian is the foremost expert on privately held companies, and he has been published and quoted in most major media outlets. He is an original architect of the company's artificial intelligence technology, FIND, the leading financial analysis technology for analyzing private companies, used by thousands of financial institutions and accounting firms. Brian also founded Inmates to Entrepreneurs, a community outreach program focused on teaching ex-offenders to start low-capital businesses.

Brian has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.