What’s missing from Twitter’s IPO

October 31, 2013, 10:54 AM UTC

It’s a familiar story: A spectacularly growing Internet company files to go public. Investors are asked to ignore its losses and value the company on revenue growth. Profits, the theory goes, will arrive in due time.

Investors have been burned by this scenario before. But Twitter, the money-losing social network that is flying to the public market a year after Facebook was awarded a $100 billion valuation, is different, right? Perhaps not as much as investors think.

Twitter stacks up nicely against its rival — in the ways that many analysts value web hatchlings. Its revenue more than doubled in its most recent quarter compared with last year; Facebook’s grew 53%. Twitter users jumped 39%; Facebook, half that. Applying Facebook’s current stock multiple of 20 times revenue to Twitter’s most recent results, you get a valuation of $11 billion, in the range of where the IPO is expected to be priced.

Yet Twitter and Facebook differ in one glaring way. Twitter doesn’t have profits. Facebook does, and did for three years before it went public. (For reference, LinkedIn was in the black when it went public, and Google had been generating earnings for several years.) Profits aren’t necessarily the only — or even the most important — thing to consider. In fact, investors often focus too much on the quantity of earnings rather than their quality.

Still, Twitter’s losses are the worrisome kind. It’s losing money because of recurring costs that are growing at the same clip as its revenue. The largest two expenses grew 107% in the nine months ended in September compared with the previous year. Research-and-development spending alone swallowed nearly half its revenue. (The other top expense was “cost of revenue,” which covers much of Twitter’s overhead.)

It wouldn’t be so worrying if those costs were going to fall soon. But in its prospectus, Twitter says they “will increase … for the foreseeable future.” If an investor were to extrapolate its current results, Twitter would only get further in the red.

R&D expenses can be high when a tech company is growing, particularly in social networking, where scale is important. Still, other successful tech companies translated their spending into profits before tapping the public markets. LinkedIn’s R&D costs were 25% of revenues. Facebook’s were around 15%. Google’s were less than 6%.

Jay Ritter, a finance professor at the University of Florida’s Warrington College of Business, says tech companies that were profitless at the time of the IPO (and had more than $50 million in revenue) and went public between 2001 and 2011 have underperformed the market by 4.8%, vs. the 7.1% outperformance by those that had a profit. There are always exceptions, of course, but history tends to be instructive.

This story is from the November 18, 2013 issue of Fortune.

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