Unless the government is the selling shareholder, it is usually a good idea to stay clear of new flotations or initial public offerings (IPOs) on the stock exchange. That's because the seller is usually cashing out a high price, especially if the owner is a venture capitalist or private equity company.
Just Eat (LSE: JE)is a classic and extreme case of this. The company acts as a middleman, allowing customers to order takeaway food over the internet. The plan is to scale the business across the world and make lots of money.
Given that it is essentially a website, it has a lot of fixed costs, so the scope for big profit gains is huge if the number of orders grows rapidly.
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However, it seems that the valuation of this business can only be justified with some very heroic assumptions about future profits growth. The 260p per share float price valued the business at £1.46bn. To put this in perspective, this amountsto 218 times the £6.8m trading profits it made in 2013.
A mature business with the same market value might have trading profits of around £150m. Just Eat has a lot of growing to do.
A read through the prospectus something you should alwaysdo reveals a lot of risks about this company. It makes moneyby charging takeaway restaurants a fee of around 10% of theorder value. That is a lot of money to give away, and might notbe sustainable.
Also, Just Eat makes a decent amount of money from credit anddebit card charges. Instead of just covering the card processingfees, it charges an extra margin on top, which makes itparticularly bad value for customers. This accounts for around12% of Just Eat's revenue.
The practice of charging more thanthe processing fee has been banned in Denmark. If it happenselsewhere, then profits could take a hit.
What's even more worrying is that the company's IT modelis not protected by any patents, which leaves it vulnerable tocompetition. Barriers to entry are essential for businesses tomake big profits, and Just Eat doesn't seem to benefit fromthem. These shares look like they could fall by a long way.
Verdict: stay away
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