What is an Initial Public Offering (IPO)?
A private company that offers its shares to the general public conducts an initial public offering. To prepare for the IPO, the company will register with the Securities and Exchange Commission (SEC) and file important securities paperwork, and it usually lists on a major exchange like the New York Stock Exchange or NASDAQ. Individual investors can purchase shares when they become available in the public market.
Benefits of Buying IPO Shares
Buying shares in an IPO can be attractive. A block of common stock purchased during the IPO has the potential to achieve substantial capital gains over decades. Even the annual dividend income from a highly successful company can exceed the original investment amount over many years.
Your investment provides capital to the economy, enabling companies that offer real goods and services to grow and expand. Learning how to buy IPO shares can lead to very appealing outcomes when conditions are favorable.
Note: Consider the value of Coca-Cola shares purchased at the company’s IPO. Set the price of one share at $40 in 1919. After more than 100 years (and several stock splits), an investor who bought one share in 1919 would now have 9,216 shares. With a value of $62 per share, which is the average closing price of Coca-Cola shares over the 52 weeks leading up to December 20, 2022, the original investment would have grown to be worth $571,392 – not accounting for annual dividends.
Disadvantages of Investing in IPO Shares
The biggest disadvantage for IPO investors is dealing with stock price volatility. It can be difficult to remain invested when the value of your shares declines.
Many shareholders do not stay calm when prices drop. Instead of valuing the business and buying accordingly, they turn to the market to inform them. However, in doing so, they fail to understand the difference between intrinsic value and price.
Instead, look at whether net earnings and earnings growth are increasing and are poised to remain that way.
Note: Not all IPOs have a happy ending. Consider Webvan, a grocery delivery company during the dot-com era. In business for only three years after its IPO in 1999, Webvan lost hundreds of millions of dollars. Investors who bought at $26 a share at the IPO (and saw a 58% growth on the first day) and continued to hold their shares would see their share value eventually decline to $0.06 per share when the company filed for bankruptcy in 2001.
The Classic View on Investing in IPOs
Benjamin Graham, the father of value investing, recommended in his book “The Intelligent Investor” that investors avoid all IPOs. The reason? During the IPO, former owners try to raise capital at a high price, providing little opportunity to buy your stake at a discount.
Instead, he suggests waiting for some trouble in the business, which will cause the stock price to collapse within a few years and provide an opportunity to buy shares at a discount.
Graham’s stance is one of cautious, disciplined safety. It reduces the risk of getting burned, and is likely to serve the average investor well in the long run by adhering to this principle.
How to Evaluate Buying IPO Shares
If you decide to buy IPO shares, consider the strength of the company itself. Ask yourself some key questions:
– If this company does not grow at a sufficient rate to justify its price, what might be the likely reasons? What are the chances of those failures?
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What are the competitive barriers that protect the company? Are there patents, trademarks, key managers, or any other unique factors that safeguard it?
– What prevents another company from entering and destroying the economic advantages?
Also consider your personal comfort level with the company and how it is managed: Would you be comfortable owning this company if the stock market were closed for the next five, ten, or twenty-five years? In other words, is this business model and the company’s financial foundation sustainable? Or is the variability resulting from technological advancement or a lack of sufficient capital possible? If the stock price drops by 50% due to short-term business issues, will you be able to continue holding your shares without any emotional response?
Do the necessary research on the company and its prospects before putting in capital. It may be difficult to do so, as the company often does not disclose much financial information until then, but it is crucial to your success.
Conclusion
The odds are stacked against you when it comes to investing successfully in an initial public offering (IPO). IPOs, as a category, do not perform very well compared to the market. Their prices are often set perfectly.
Before you invest, find out what you are looking for. Consider that you may need to wait patiently, perhaps for years, for the right opportunity at the right time. Sometimes this opportunity arises in an IPO, but most often, it will require discipline, timing, and research.
Frequently Asked Questions (FAQs)
How can I buy shares before the IPO?
Before the company goes public, it may offer some discounted shares to private investors in the form of pre-IPO placements. These are shares sold privately and therefore not regulated by the U.S. Securities and Exchange Commission (SEC). They are also available only to accredited investors, so many individual investors may not be able to buy them. If you are approached to buy shares before the IPO, be wary of potential fraud and conduct your own research.
How is the IPO price determined?
Determining the IPO price is a complex process. It is done by the lead investment bank that is underwriting the IPO and is based on the company’s financial situation, valuations of comparable companies, and the sales skills of those setting the price.
Source: https://www.thebalancemoney.com/should-you-invest-in-an-ipo-357844
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