IPOs

What are IPOs?

An "initial public offering" is a company's first sale of stock to the public. This is why it is also referred to as "going public". When a company that has already issued stock issues more stock it is called a "secondary offering".

Why do companies do IPOs?

The biggest reason companies do IPOs is to raise capital to meet the capital needs of the business. If a small company is doing $100 million in sales and it believes it could get up to $2 billion then it might take a while if it's growth is funded from internal profits. So it sells part of the company to investors (the public) and uses the money to grow quicker than it would have otherwise.

Another reason companies go public is to make it easier to acquire other companies. Buying other companies requires a lot of cash. Doing an IPO allows them to raise cash as well as have a publicly traded stock that they can use as a currency to buy another company (called a "stock swap").

Another reason a company will do an IPO is to create liquidity for their stock options programs. If a company is a private company and they give out stock options to employees then there is no public market for them to trade on. Having a publicly traded stock makes it easier for option holders to realize the value of their options.

Being a public company can also give you cachet because people tend to trust a company more if it is public. A small company looking to create a strong brand with their customers may be able to use their status as a publicly traded company as a marketing tool - although this reason by itself is rarely enough for a company to do an IPO.

How is an IPO done?

The process by which an IPO is issued is called an "underwriting". When a company wants to go public they contact an investment bank (usually one of the big ones on Wall Street) and hammer out the terms of the deal (like how much money to raise, how many shares to issue, etc). The investment bank agrees to sell the shares to the public. Sometimes the investment bank will agree to buy the shares directly from the company and re-sell them to the public. Many times a single investment bank will not want to shoulder the whole risk of an IPO so they will team up with other investment banks to form what is called a "syndicate" where one bank is the lead underwriter. Any investment bank involved in the IPO will earn a commission based on a percent of the money raised in the IPO.

There have been attempts over the past few years to revolutionize the IPO process by eliminating the investment banks from the IPO process. None of these efforts have gained any substantial traction. Personally, I think the IPO market is ripe for innovation because one of the big trends over the last few years in business has been to mitigate the role of the middleman. And the investment banks who act as middlemen in the IPO process earn enormous fees for doing so. Although some people may point out the risk involved and how complicated the process is, I believe there is considerably less risk than say deriving your income from correctly calling market trends. The big Wall Street investment banks seem to get the all the business only because they are large and prestigious. But I believe some of the medium-sized financial firms who don't have much market share in IPOs would do well to under price the big Wall Street firms. The process of doing an IPO, after all, has been around for a long time and does not require unique technology.

The IPO market

If you read the business news regularly you will see people referring to the "IPO market". They are referring to how many companies have gone public recently and how many are scheduled to go public soon. Even investors who don't buy IPOs usually keep an eye on the IPO market. This is because the IPO market is an indicator of the public's hunger for stocks in general.

Because IPO activity is somewhat of a gauge of supply and demand for equities, the IPO market is commonly used as a contrary indicator. In other words, when tons of companies are doing IPOs then it means people are euphoric about the market and it is probably time to sell. The dotcom era of the late 90's was one of the best examples in history of using the IPO as a market indicator. If you want to get technical, you could graph the number of monthly IPOs and overlay it onto a stock index chart. If you want to monitor the IPO market here are a few indicators you can use:

The number of IPOs this quarter vs. the same quarter last year.
The number of IPOs last quarter vs. this quarter.
The return of the IPOs on their first day of trading.
The return of all IPOs year-to-date.
The quality of the companies going public.
How many IPOs get delayed because of lack of demand.
The total market cap of all IPOs this year vs. last year.

Getting in on an IPO

Investment banks generally give out access to IPOs to their most valuable customers. This is why IPOs are mostly sold to institutional investors, although they are sometimes sold to retail investors who generate large commissions. Some retail brokerages, as a way to differentiate themselves from the competition, have started to give their smaller retail customers access to some of the IPOs that they had a part in underwriting. This practice is not very popular and probably never will be.

The truth about (some) IPOs

I talked earlier about how the reason that a company issues stock was to raise money to meet the long-term capital needs of the business and many times to fund the company's growth. Well, this was based on the assumption that the owners of the company believe that the best times for the company are in the future so the company needs to raise money if it wants to take advantage of these opportunities.

But one of the things that is rarely mentioned is that sometimes a company is taken public because the owners believe the best times for a company (from a valuation standpoint) are behind it. In this case the IPO serves as an "exit strategy", or a way to sell the company so the owners can cash in their profits.

Some investors may think this is unfair. But as long as there is enough information for investors to make an accurate assessment of the company's value then it isn't. If investors want to pay too much for a stock based on that information then they have a right to do that. Most investors operate under the illusion that all IPOs are growth companies with great prospects. People forget sometimes that the IPO process is simply a process where a seller sells a stock to a buyer. An owner of a stock usually sells the stock because they think the value has been realized. This happens with IPOs too.

My opinion

This first thing beginners need to learn about IPOs is that IPOs are nothing special. One of the biggest areas where amateur investors show their flaws when it comes to investing is with IPOs. Amateur investors are often seduced by IPOs because they believe that the companies going public are somehow better investment opportunities. They're not. They are just regular companies just like all other companies. There will be opportunities where there IPOs that are way underpriced but those opportunities are no different than opportunities in stocks that have been trading for a while.

I do sometimes trade recent IPOs but, overall, I am less likely to buy a stock if it a recent IPO. This is because I have 4 problems with IPOs:

First, there is very little fundamental information about the company to analyze. When I buy a stock I like to see at least the last 2 years of annual and quarterly income statements so I can calculate the year-over-year growth rates in earnings and revenue. If it is a stock I have more confidence in for some reason (maybe I know the company well enough to know it's growth rate) then the very least I would like to see is last year's EPS or an estimate for the current year's. But sometimes even this is hard to find. Finding fundamental information on IPO companies can be a pain in the ass too because a lot of it will be buried in long documents filed with the SEC. Even though these documents are publicly available, the information takes longer to find because it is not just given straight to you like on Yahoo Finance.

The second problem is that the investing community at large has not scrutinized the company’s financials over a long enough period of time. It is very common for a company to do an IPO and then 3 months or so down the road it's stock will drop 30% in 1 day because their sales or earnings came in lower than expectations. This happens all the time. Usually a week after it happens you will see that the company's news page on Yahoo Finance is filled with news releases from many different law firms filing investor class action lawsuits against the company. This happens because the information in the IPO prospectus was incomplete, false, or misleading.

Third, because there is no trading history, I don't know what the market's opinion on the stock is. A lot of amateur traders reading this may consider this non-essential but I assure you it's not. Any sound analysis of an investment must take into consideration the market's expectations.

And finally, the last problem I have with IPOs is that the lack of trading history means there is no support and resistance levels on a chart, which is one of my major criteria when screening stocks. Therefore, there is less technical analysis that can be done.

I'm not saying that IPOs aren't worth looking at. But because they carry specific risks that other stocks don't, you have to be that much more confident in the other pieces of the puzzle. On the upside, IPOs do sometimes give you good opportunities because they tend to be pretty volatile. Also, they often have a habit of following into the same patterns of rising for a short-term right after the IPO, then dropping to new lows. From there the bad companies tend to continue falling and the good companies turn around and starting a sustained up trend.

Education > Investing > Stocks > IPOs

IPOs

What are IPOs?

Why do companies do IPOs?

How is an IPO done?

The IPO market

Getting in on an IPO

The truth about (some) IPOs

My opinion

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