An IPO is the one-time event when a private company takes it’s company public by listing it’s shares on a stock exchange.
Going public through an initial public offering (IPO) of stock can be an effective means of raising cash for corporate ventures. And with proper research, IPOs can bring investors a great return on their money.
But before undertaking the investment, you must understand the upside and downside of IPOs.
With news of investors making millions on their investments in an IPO, it makes sense that other investors would be interested in following their lead and getting in on new IPOs.
Because today’s IPO market is filled with company that are launching new ideas and innovative technology to the public, there are many pros and cons to IPOs that you must understand.
IPOs come in many types and there are many factors to be carefully considered before you consider investing.
In this post, the information you’ll discover will serve as a starting point for your own investigation for investment in IPOs.
Why Do Companies File IPOs?
As a privately-owned company, it can grow only so big before capital for continued growth becomes scarce. For example, their main capital sources during the early growth phase may be venture capital or even bank loans. But there’s a limit to how much money can be accessed through those sources. What’s more, bank loans require loan payments. And venture capitalists expect a certain return on their money.
It’s just a question of time before a fast-growing company needs to consider going public to obtain the capital they need. By going public, the company avoids the debt obligation that comes with bank financing and the control factors that may be imposed by venture capitalists.
This is the basic reason companies go public. Virtually every one of the companies listed on public exchanges had to make that transition at some point. The ability to raise capital through the sale of stock is the reason so many companies have gotten as large as they are.
Before investing in an IPO, consider these points…
Investing in an IPO Key Point #1
Relying on the media or the “public” to inform you about the viability of an IPO may not be the safest strategy for your future financial self. Even a well-known or media hyped company can be a poorly run company, leading to a bad investment and loss of your money. Don’t invest in an IPO simply because the financial media is fawning over the company. Excessive media may drive the stock price up, increasing the valuation and risk for long-term success.
Keep in mind that IPOs are often companies without a long track record of public transparency. This makes the company harder to investigate as a reasonable investment vehical.
Also, the industry that the company is operating in could play a role in the IPO’s performance, as well as the long term success of the company. These issues and more could dampen the success of an IPO and take your investment capital in the wrong direction – down.
Investing in an IPO Key Point #2
Investing in an IPO will give you a higher return than waiting to invest in something else. This is not always true, as there are too many factos to consider other than the timeingof the IPO.
Remember, young companies are seen as more volatile and riskier than other, more mature companies. This risk may translate to higher reward, but it may also translate to a losing position.
In general, not all IPOs are long term winners. Remember, these are companies operating in highly competitive market under stressful conditions. The failure rate for a company is high. And if you have your money behind a company, you want to make sure that you come out on top, by putting your funds into a company that has a good chance of succeeding.
While you will always see the financial media hype cycle talk about the big IPOs and the winners with triple digit returns, there are many, many examples of IPOs that faltered and failed to bring investors an adequate return.
It may be true that projected future growth fuel more attention to IPOs and startups about to go public. And usually investors are willing to pay more for future growth. However, the future is never certain, so care must be taken when you are evaluating an IPO for an investment.
Investing in an IPO Key Point #3
Just because a company is going public, it does not mean that the company is financially stable.
The success of a company is never guarantee. Rememer, a company is operating in a situation with many factors that are beyond it’s control. There are competitors to consider, industry changes, shifts in consumer behavior, government regulation, taxes, tariffs, and market cycles, all of which influence and affect the future growth prospects of the company. Even though an IPO will have audited financial documents, this data is only one part of the picture.
That said, the financials of the company can be a solid starting point for all investors. These documents can be found in public databases, as well as the SEC website. The forms are called Form S-1. After you reviewing the information in these documents, you will have an solid understanding of the business and its operations. With this information, you can analyze the company and figure out a reasonable valuation for the IPO.
With those points under your belt, you’ll have a better time figure out if an IPO is the right investment for you. Here are a few additional thoughts on IPOs.
Pick a company with a good broker
Underwriters are an integral part of an IPOs success, so review the companie’s choise of underwriter. Overall, an investment bank with a strong reputation will more likely support a strong company and get behind their IPO. Likewise, newer investment banks may or may not support a solid IPO, but you will need to give them an extra eye. Smaller brokerages may be willing to underwrite any company.
On the other hand, small, more boutique brokers may make it easier for the individual investor to purchase pre-IPO shares. This may or may not be a positive thing. It depends on the company. Usually, the only individual investors who get in on IPOs are long-standing, established, and often high-net-worth customers.
Do your due diligence before investing in an IPO
Always do your own due diligence when considering an IPO. AS you just read, most of your questions about the company can be found online in the Form S-1. Use the data in these pages to perform your own due diligence and then you’ll have an solid understanding of the business and its operations.
Never skip reviewing these documents. These documents are prepared to provide transparent to private investors about the company, so use them to your advantage. The documents provide insight aout the company, discuss the potential risks, and discuss the future uses of the money being raised with the IPO. Use this information to inform your investment decisions.
In your reading, keep an eye out for overly optimistic future earnings projections. Over-promising on projections often leads to disappointing announcements later when the company didn’t hit it’s projections. This leads to a decrease in investor confidence and may encourage investors to move their money somewhere else, causing the price to drop. It’s very important to read pre-IPO documents very carefully.
With the information found from your due diligence, you can analyze the company and figure out a reasonable valuation for the IPO. You can also use the other valuation strategies discussed in this article to decide if the IPO price is justified or not.
Final Word and Wrap Up About IPOs
Making the determination about the safety of an IPO is up to you and your own personality.
Concern and skepticism can be a healthy advantage when considering your investment options in an IPO market. As you just read, there exists uncertainty with IPOs, mostly due to the lack of available information in the operating history. Therefore, it’s best to err on the side of caution.
This is particularly true when you evaluating IPOs that you hear discussed in the media. When new IPOs are discussed in the media, there are many factors that influence the news, and the long-term prospect of the company may not be one of them. Sometimes, an IPO gets a great reputation on Wall Street and the media will simply write about it because other companies are publishing stories on them. Be sure to consider the company carefully, but especially if it seems to be riding the wave of a positive media cycle.
That said, with the right research, and if an IPO takes off, it can bring you an oversized returns. Investors who got in early on the IPOs of Amazon, Facebook, and Google are likely millionaires today.
Today, there are many IPOs launched each year, so you can use the information in this article to determine the valuation of the ones that you are interested in. The techniques in this article will allow you to do your own due diligence and possibly uncover the next big IPO winner.