Reddit, which will soon launch an Initial Public Offering (IPO), is a great company but may not be a sound investment.
It's a great company because it has a high following among online communities and is actively involved in discovering, discussing, and sharing content on highly controversial topics. They make it one of the most popular online social media platforms; some call it "the front page of the internet."
Social media platforms that keep users actively engaged make outstanding investments. Active users generate controversy, which feeds into positive WOM and buzz for the platform and the brand.
Positive WOM and buzz, in turn, help these platforms attract traffic and monetize their business model by selling advertisements and premium paid subscriptions. According to Business of Apps, Reddit currently has 70 million daily active users and approximately 850 million users who use it once a month. They helped it generate $810 million in 2023, primarily from advertising.
However, more than these revenues may be needed to make it a good investment, as it is preparing for an initial public offering (IPO) on Wall Street.
Kraig Kleeman, Founder and CEO of Z-Branding, summarized Reddit's investment problem with a few sentences.
"Beyond the buzz, the pivotal factor in our analysis is Reddit's financial health," he said. "While the platform boasts commendable user engagement and robust ad revenue, lingering questions surround its profitability. As astute investors assess the IPO, thoroughly examining these financial metrics becomes imperative to discern whether Reddit stands as more than a mere social media sensation."
Robert Johnson, PhD, CFA, CAIA, Professor at Heider College of Business at Creighton University, puts Reddit's IPO into perspective. "Reddit is unprofitable, but that is not uncommon for IPOs in recent markets," he said. "A worrisome sign for the IPO market is the percentage of IPOs of unprofitable companies. "
Johnson quotes data from Statista confirming that the share of profitable U.S. companies after their IPO has been falling since a decade-high of 81 percent in 2009. In 2020, this figure had dropped to only 22 percent, which may spell bad news for this form of raising capital, but then slightly recovered in 2021 and 2022.
"The number one mistake retail investors make with IPOs is confusing a good product with a good investment," Johnson added. "UBER and LYFT are prime examples. One can love a product or service, but that does not make the company a good investment."
Five years after the IPO, UBER's shares barely beat the S&P 500, while LYFT's shares are down 64%.
Johnson thinks a firm must have a sustainable business model to be a good investment. "One may want to investigate companies that sell products or services they enjoy," he explained. "However, the key is to take the next step and determine the company's valuation. As with any investment, due diligence is paramount. But it is especially critical in valuing IPOs."
Kleeman has a few more tips for investors evaluating IPOs these days. "An essential context to consider is the transformed landscape of initial public offerings since the 'dot-com bubble' era," he said. "Companies now often opt for later-stage IPOs, entering the public domain armed with mature financials. Nevertheless, the specter of a 'junk IPO' endures, emphasizing the perpetual importance of profitability and sustainability in navigating today's dynamic market."
"Junk IPOs signal that investor sentiment has gotten carried away," added Jeremy Bohne, founder of Paceline Wealth Management, LLC. "The completion of a 'big, dumb deal,' as opposed to it falling apart, tells investors that many people are being irrational. This can precipitate a market pullback as seasoned investors begin to reduce risk."
Still, Kleeman doesn't think Reddit is a 'junk IPO,' encouraging investors to approach this complex scenario with "a discerning eye, peeling back layers of online excitement and scrutinizing Reddit's financial standing for an informed decision-making process."
"In navigating this dynamic realm, distinguishing substance from spectacle remains paramount," he added.
