Why I didn't go all in on the Airbnb IPO

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

In an article published on Dec. 7, I named Airbnb (NASDAQ: ABNB) as my top initial public offering (IPO) stock to buy in December. It has been years since an IPO intrigued me so much, and I took the rare step of selling other stocks in my portfolio in order to buy more shares of the prominent online rental marketplace.

When the initial pricing range for the Airbnb IPO was announced, I planned to make its stock my biggest purchase of the year and one of my biggest holdings. However, my view of the deal eventually changed, and I avoided making a big investment. Here's why.  

The hype was overwhelming, but valuation still matters

Airbnb is a great company. With an easy-to-use platform that connects travelers and renters with property owners, it has already disrupted the hotel and vacation-rental industry and has plenty of room for long-term expansion. When the initial price range for Airbnb stock was announced at between $44 and $50 per share, valuing the company at as much as $35 billion, my eyes saw dollar signs.

My basic expectation was that shares would probably follow the trend for tech IPOs this year and be bid up well above the IPO price in early trading. However, I still saw plenty of opportunity for big gains on day one and beyond if I could get shares early. In fact, I figured the company had a good chance of reaching a valuation of $100 billion within the next six months.

Then, Airbnb increased its projected IPO pricing range to between $56 and $60 per share -- valuing the company at about $42 billion. My thesis held with this first bump, and the news didn't come as a surprise. Many high-profile tech companies that went public this year also raised their pricing ranges following the initial announcement.

However, things started to look different by the time Airbnb revealed on Dec. 9 that it would be pricing the IPO at $68 per share. The implied valuation of roughly $47 billion was still well below my near-term target level, but warning signs that the IPO was becoming too hot for me were starting to pile up. 

Tech IPOs have been extraordinarily hot this year

By the time Airbnb's first day of trading rolled around -- Dec. 10 -- reports emerged that the stock would likely open with shares trading in the range of $150 per share. It's important to understand how the company's valuation could more than double before shares even became available to the average investor.

Companies seeking to go public typically turn to large financial institutions to function as underwriters that help with the process. These financial institutions distribute shares to large institutional investors at the IPO price, who then sell shares to smaller but still very large investors before the stock becomes available to the typical retail investor.

In Airbnb's case, Morgan Stanley and Goldman Sachs functioned as the lead underwriters in the IPO. These institutions apportioned shares to large investors, who then offered the shares in a round of early auction trading that wasn't available to most of the public. Retail investors like me had to contend with the fact that they are at the bottom of the IPO food chain. 

The market for tech IPOs has been strong, and many companies saw their stocks bid well above their initial listing price before the average investor could get their hands on any shares. The following table looks at some other notable tech IPOs this year and compares their IPO price with their opening price when the stock finally began trading on the market:

Data sources: company filings and Yahoo! Finance. *Palantir went public via direct listing.

Predictably, Airbnb followed suit. Shares opened at $146 per share -- 115% higher than the actual IPO price and 192% higher than the top of its original pricing range. That meant the company opened with a market capitalization of roughly $102 billion.

I'm still a big believer in the company, and the hype was tempting. But I opted not to buy in at a level that exceeded my target valuation, at least not to the extent I had planned. 

What happens next?

I wound up passing on Airbnb stock on its first day of trading, but I did purchase a very small number of shares the following day. I was able to buy significantly below opening-day trading prices, but my purchase was small enough to be largely symbolic. 

I think Airbnb has the potential to post strong long-term growth and significantly exceed a valuation of roughly $100 billion. However, I knew that I'd have been getting caught up in hype and ignoring my initial analysis if I went through with making a large investment in the company. My small purchase was a nod to the company's potential and a psychological anchor to provide extra motivation to follow the business closely and monitor ongoing opportunities to buy the stock. 

Greed can be good, but it pays to be principled

With 471 companies having gone public on the U.S. market year to date, there have been more IPOs this year than ever before. The size of this year's IPO class surpassed the record previously set in 1999, and more companies have opened trading at double their IPO price than any time since that much-studied year.  

Analysts and market watchers have compared IPO trends across these record years and noted that 1999 was the height of the dot-com bubble, which raises some red flags. The case can be made that the tech economy is at a much more advanced stage than it was roughly two decades ago, while also having a future that's brighter than ever. At the same time, it's clear that some valuations in the tech sector have become stretched, and investors buying on momentum has played a big role in IPO performance.

I still love Airbnb as a company and rate its prospects higher than most of this year's other notable tech IPOs. Despite challenges brought on by the coronavirus pandemic, the business has a promising growth outlook. Strong gross margin, a leadership position in its service category, and unmatched brand strength point to huge potential. 

On the other hand, I made the decision not to follow through with a large investment, because it would have meant throwing out key foundations of my investing thesis to chase market buzz. It's possible that Airbnb will go nowhere but up from current prices and that I'll come to regret my decision. However, restraint can be a virtue, and I'm confident that sticking to the principles that shaped my decision will lead to better long-term performance across my portfolio.

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.