An IPO or Initial Public Offering is the first time a company that is applying to be listed on the stock market sells it shares to general public at an initial price i.e. listing price.
It’s the process through which a privately held company transforms into a public company.
From the cursory appearance it seems that the initial price is the best bargain price anyone can get for a stock, making IPO a bargain for an investor.
But is that really so?
Let’s first succinctly explore the process of an IPO and the factors that decides the initial offering price and the price once it starts trading on the stock market.
The IPO Process
The company that is to go public is known as issuer.
Underwriters are the investment bank that helps in the process of IPO for a fee and these are the one that approaches investors with offers to sell those shares and provides information about the company in a document known as prospectus.
The prospectus contains description of the company’s business, financial statements, information about officers and directors of company and their compensation, any litigation that is taking place, a list of material properties etc.
Then the approximate price at which the shares should be issued is determined.
While deciding this price several things are taken into consideration like, it should be low enough to stimulate interest in the stock and at the same time high enough to raise an adequate amount of capital for the company.
If a stock is overpriced then the stock may fall in value on the first day of trading and if it is under-priced then the capital raised could be insufficient.
After the IPO, when shares trade freely in the open market the price will be decided as per demand and supply of the share.
Also, when a company becomes public they will have stringent reporting requirements and they will be under greater public scrutiny and their ability to focus on longer term growth is somewhat reduced.
All these factor will affect there working as a public company and future earnings.
Let’s try to apply some of the principles of value investing as a yardstick to effectively evaluate IPO as an investment :
Is listing price a bargain price?
One of the basic thing to remember about IPO is that it is an expensive process and the initial offering price do cover these expenses and therefore most of the times the stock is overpriced at listing price.
Do we know about the company well before IPO?
For a value investor, what matters most about a company is its financial history.
In the case of a company that is still not listed on the Stock Market, this information is mostly private which means it is not easy to access and most of the time unreliable.
In case of an IPO, prospectus do cover some of the earning history and description about the business but this information was once private and not scrutinized to the level any value investor wants it to be.
Is the business predictable?
Another important point that we need to pay attention to, is the possible effects of stringent rules and scrutiny that will be applied to the business once it’s listed on Stock Market.
Most of the businesses do not react well to these requirements and their stock price follows it.
But…it’s very popular!
Being very popular sometimes inflate the price of the stock after IPO, due to a feeling of missing out by many people.
The feeling of missing out on the massive gains leads to an initial hysteria leading to spike in price just after IPO making it heavily overvalued.
But once the initial frenzy wear out, the business has to justify the price and that is often a very difficult thing.
Advice from Master
The following quotes from Warren Buffet summarized his opinion about IPOs.
“You don’t have to really worry about what’s really going on in IPOs. People win lotteries every day but there’s no reason to let that affect [your investing strategy] at all,”
“You don’t want to get into a stupid game just because it’s available.”
– Warren Buffet
Risks associated with IPOs are substantial and it does not fall under the purview of sound value investing principles.
So the verdict from the point of view of any value investor tends to be:
“Avoid IPOs however lucrative they seem”
*All Images from CC0 Public Domain