Will Snapchat’s IPO flourish like Facebook’s—or tumble like Twitter’s?

Snap Inc., the parent company of the Snapchat app, went public last week, netting the tech giant $3.4 billion through the sale of 200 million shares. Photo by Matthew Modoono/Northeastern University

Snap Inc., the parent company of Snapchat, went public last week, netting the tech giant $3.4 billion through the sale of 200 million shares. But stock in the company has already begun to fall, dropping 10 percent from Snap’s stock market debut, and Wall Street analysts are warning people not to buy it.

We asked assistant professor Kuncheng Zheng, a corporate finance expert in the D’Amore-McKim School of Business, to explain why analysts are so wary of the biggest tech IPO since Facebook and whether Snap’s plan to turn $500 million in losses into profit is wishful thinking or a stroke of genius.

Snap has yet to receive a “buy” rating from any Wall Street analyst, including one who cited Snap’s slow user growth and fierce competition from larger rivals like Facebook as two of the primary reasons for his skepticism. In your opinion, should people buy Snap stock?

In academia, we always recommend investors buy a well-diversified portfolio as a whole instead of buying individual stocks. The structure of these portfolios is usually designed to make sure that all the risk of the portfolio is fairly compensated, and the uncompensated risk is diversified away. Following this logic, I don’t recommend buying Snap stocks separately. Buying Snap separately is likely to make an investor bear some uncompensated risk—that is, paying too much now for the cash flow they will get in the future from the Snap stocks.

Snap is a firm with high risk, especially uncompensated risk. For example, the two co-founders of Snap have almost all the voting rights. This means that, unlike other firms, they cannot be replaced even if they slack off. This is a kind of uncompensated risk. If you really want to buy Snap stocks, think of it as buying a lottery ticket, and make sure the amount of money you spend on it only accounts for a small amount of your trading account.

Snap lost $515 million in 2016 and warned in its recent Securities and Exchange Commission filing that it “may never achieve or maintain profitability.” But reports suggest that the company plans to increase revenue by recreating TV ads on Snapchat to boost engagement of the highly coveted 18-to 34-year-old demographic, thus wringing out more money per user. Do you think this strategy could lead to profitability, or will Snap tumble like Twitter, whose growth has stalled?

Social media is already a competitive market with a few strong competitors. And the value of a social media network is closely related to its user base and their purchasing power. Currently, more than 75 percent of Snapchat users are younger than 35 years old, and their purchasing power is significantly lower than those in the 35 to 64 bracket. In my opinion, to increase revenue, Snap needs to not only wring out more money per user, but also increase its user base. In fact, as a relatively new competitor in the social media network, talking about wringing out more money per user instead of increasing its user base gives me an impression that the potential of Snap is close to exhausted. Without much ability to increase user base, it would be hard for Snap to become profitable considering the $500+ million loss in 2016 and the company’s 1,800+ employee base.

Scores of Snapchat’s young users have been snapping up Snap stock. What role might young investors’ keen interest in tech companies play in other business’ decisions to go public this year, including Uber, Dropbox, and Airbnb?

Snapchat’s young users have been active in buying Snap stocks. Some of them are optimistic about the future of Snap because they and their friends use Snapchat intensively. However, they might not have seen the big picture. That is, as mentioned earlier, more than 75 percent of Snapchat users are younger than 35 years old, and the growth in older users is slow. Some Snapchat users do realize that Snap might be overvalued. However, because they love Snapchat so much, these young investors are willing to pay a high price to own part of the company, even though they have no say in how Snap is run.

Due to the presence of these optimistic and loyal young investors, the price of stocks can rise higher than their fundamental value. However, since the purchasing power of these young investors is much smaller than those of older investors and institutional investors, this kind of deviation is likely to be temporary. So I don’t think this optimism among young investors would affect the IPO decisions of other private firms.