IPO Basics
As the company starts growing, there is a time when it needs huge capital to
take it to the next level of growth. Some companies decide to raise debt to get
this capital; others opt for profit sharing without adding to the debt. The
second option is the IPO route. In effect, when you invest in an IPO you are
opting for part of its profits and losses too! So you need to be very selective
on which companies you want invest in.
No History
It's hard enough to analyze the
stock of an established company. An IPO company is even trickier to analyze
since there won't be a lot of historical information. Your main source of data
is the red herring, so make sure you examine this document carefully. Look for
the usual information, but also pay special attention to the management team
and how they plan to use the funds generated from the IPO.
And what about the underwriters?
Successful IPOs are typically supported by bigger brokerages that have the
ability to promote a new issue well. Be more wary of smaller investment banks
because they may be willing to underwrite any company.
Studying the Company
A good starting point for your IPO analysis is to look at the financial reports
of the company for as many years as possible. One thing that every company must
publish is its total debt and total asset value. As long as the asset value is
more than the debt, you know that enterprise can pay off its debts so it would
survive. Also look at the difference in the assets value and debt which in
effect is like the company value. Check what is the effective company value
based on the IPO price and number of shares. If the IPO price is less than this
value you are in for good profits on listing.
Besides value, another good indicator is the company growth seen in the profits
it has made over the past few years. Sometimes the enterprise is new, so its
current value is less, but a strong growth pattern would be that its value is
going to increase in future so it is a good longer term investment.
Third important thing to look at is whether the company is stuck in some legal
tangles. Typically, if the verdict goes against it, it would affect its
finances and more importantly the stock price in the market. You could lose lot
of money, in that case. So study these aspects well before investing.
Lastly, analyse its market standing among the peers. If you use its products,
you know it is a good company and you can invest with lesser risk. But if it is
an unheard commodity, you need to be cautious.
The Lockup Period
If you look at the charts
following many IPOs, you'll notice that after a few months the stock takes a
steep downturn. This is often because of the lockup period.
When a company goes public, the
underwriters make company officials and employees sign a lockup agreement.
Lockup agreements are legally binding contracts between the underwriters and
insiders of the company, prohibiting them from selling any shares of stock for
a specified period of time. The period can be anything from 3 to 24 months. The
problem is, when lockups expire all the insiders are permitted to sell their
stock. The result is a rush of people trying to sell their stock to realize
their profit. This excess supply can put severe downward pressure on the stock
price.
Flipping
Flipping is reselling a hot IPO
stock in the first few days to earn a quick profit. This isn't easy to do, and
you'll be strongly discouraged by your brokerage. The reason behind this is
that companies want long-term investors who hold their stock, not traders.
There are no laws that prevent flipping, but your broker may blacklist you from
future offerings or just smile less when you shake hands.
Of course, institutional investors
flip stocks all the time and make big money. The double standard exists and
there is nothing we can do about it because they have the buying power. Because
of flipping, it's a good rule not to buy shares of an IPO if you don't get in
on the initial offering. Many IPOs that have big gains on the first day will
come back to earth as the institutions take their profits.
Avoid the Hype
It's important to understand that
underwriters are salesmen. The whole underwriting process is intentionally
hyped up to get as much attention as possible. Since IPOs only happen once for
each company, they are often presented as "once in a lifetime"
opportunities. Of course, some IPOs soar high and keep soaring. But many end up
selling below their offering prices within the year. Don't buy a stock only
because it's an IPO - do it because it's a good investment.
Conclusion
Besides these points, other items that could affect the IPO price on listing
are market sentiments, the economic outlook, general industry news, etc. These
are so dynamic that they cannot be used a guidelines, and you need to go with
the market flow.
In short, investing in IPOs is risky, but with careful analysis you can reduce
the risk. For this there are some items to consider when investing in an IPO.
As long as you do your homework, the risks are limited.
References
