Why Zynga may not be as bad off as it seems

December 20, 2011, 4:42 PM UTC

By Kevin Kelleher, contributor

FORTUNE — Several months ago, things were looking very good indeed for Zynga. The casual-gaming company stood apart from other web IPOs of 2011 thanks to its “bountiful” profits. Investors were “excited” by an offering that could value the company at $20 billion.

Now that Zynga (ZNGA) has gone public, things are looking much different. The stock debuted Friday at $10 a share, valuing the company at a relatively modest $7 billion. After popping above $11 a share for a few promising moments, the stock quickly sunk to $9.50 Friday and fell as low as $8.75 Monday. At that low point, Zynga’s market value was $6.1 billion, a bit below LinkedIn’s (LNKD) $6.3 billion market cap — even though Zynga’s revenue over the last 12 months was twice as large as LinkedIn’s. Zynga’s market value was also less than half that of Groupon (GRPN).

Just as quickly, Zynga went from IPO hero to dog, with stories describing how its “dud” offering “fizzled.” Much of that analysis overlooked a crucial detail that says less about Zynga’s financials than it does about the backroom culture of IPO deals. Zynga always wanted to raise $1 billion in this offering. But to do that, as Reuters pointed out, it chose to forego the 15% discount that underwriters often give to IPO investors, a discount that virtually guarantees that first-day pop.

Despite the volatility inherent in newly-listed stocks, there’s a tendency to rate IPOs in a thumbs-up, thumbs-down manner, based on whether their stocks are above or below their respective offering prices. But a closer look at Zynga shows things are more complex than that. Yes, the market is right to question whether Zynga is fairly valued at its offering price. But Zynga may not be as bad off as some critics are suggesting — and it may well be in much better shape than other web stocks that have gone public this year.

Take, for example, the claim that Zynga’s debut was a dud. That’s seems true enough if you compare it to the first day performances of other web IPOs like Pandora (P) (up 9% on its first day), Groupon (up 31%) and LinkedIn (up 109%). But these companies launched with much smaller floats, offering between 5% and 9% of their total shares. Zynga offered a larger float, about 14% of its common stock.

And on the face of it, it’s also true that Zynga’s $7 billion valuation at launch was too high. At $7 billion, Zynga was worth seven times revenue and 95 times its net income over the past 12 months. On the one hand, that’s absurd by most measures. After all, the S&P 500 is trading at 14 times earnings. On the other hand, investors in Internet stocks are routinely willing to tolerate higher valuation for some web stocks. Amazon (AMZN) has a price-earnings ratio of 95, even though some analysts are predicting the company will post its lowest earnings per share since 2007. And Zynga’s PE is a relative bargain compared to LinkedIn, which is just on the sane side of 400, and Groupon, which has posted a significant loss over its past 12 months.

For many market pundits, it’s somehow easier to be easier to question Zynga’s $7 billion value today than it was this summer, when only a few were wagging their fingers at the prospect of a $20 billion Zynga. And back in February, investors were delighted to value Zynga at $10 billion, when the most recent financial data had revenue showed revenue well below the most recently disclosed figure.

What happened? A couple of things. First, Zynga’s metrics hinted at a slowdown. Active users have been declining in recent quarters. And operating margins have fluctuated downward. But these things are part and parcel of investing in the gaming industry, where you’re only as good as your last title and profits are a feast-or-famine phenomenon. Zynga hasn’t proven invulnerable to such choppy financials, but it’s doing a better job than any other casual-gaming company of churning out hit after hit.

Volatile revenues and profit margins aren’t unusual for web 2.0 companies. Look at the charts comparing Zynga’s revenue and operating margin with LinkedIn. Not only Zynga’s revenue growing steadily (if a bit more slowly, looking at the last quarter) but it’s operating margin is just as volatile as LinkedIn’s. And yet Zynga’s profit margin margin is at least three times as big as LinkedIn in any of the past five quarters.

Yet LinkedIn trades at a higher valuation. Why? Perhaps it’s because LinkedIn’s CEO Reid Hoffman is drawing profiles so fawning they border on an apotheosis, while Zynga’s Mark Pincus is depicted as a lout. Pincus was also called out for controlling Zynga’s hoarding the voting rights of shareholders. But LinkedIn employed a dual-class stock structure that also limited shareholder rights, to much less of a controversy.

None of this is to argue that Zynga deserves to trade higher. It doesn’t, but neither do most of the other web IPOs of the class of 2011. Like them, Zynga faces risks that aren’t fully reflected in their trading prices. They will all be volatile, and because of that it doesn’t make sense to write off a stock’s long-term prospects based on two days of trading.

Zynga’s lukewarm reception is the proper response to an expensive, risky stock. It shows the market is working. Now if it would only work on other overpriced web IPOs as well.