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The much-anticipated IPO of Google, likely the most popular search engine on the Internet, celebrated the return of individual investors to the IPO market. Moreover, the excitement surrounding the Google IPO topped off a five-year recovery of the IPO market. For example, IPOs increased in 2004 by 30 percent and raised over $43 billion. To the surprise of many experts and individual investors, IPOs for the Internet, energy, and cyclical products and services had the strongest returns. Overall, the 2004 IPO market com memorated four consecutive years of positive IPO returns. This is a real feat because none of the major indices, such as the S & P 500 or the Dow Jones Industrial Averages, can claim the same success.
When a company sells stock that trades publicly for the first time, that event is called an initial public offering (IPO). The United States market averages between 250 and 275 IPOs per year. These IPO company issuers sell shares to an underwriter. The underwriter, in turn, resells shares to investors at a prearranged offering price. Underwriters often underprice issues by 5 to 10 percent to ensure adequate demand. Generally, shares begin trading immedi ately on a stock exchange or over the counter through the NASDAQ stock market. About one week after issue, due to market efficiency, the excess returns due to the initial discount disappearing. This scenario indicates that the best time to purchase an IPO is on initial distribution from the underwrit ing syndicate (which includes investment bankers, dealers, and brokers). Every year, development companies and companies just starting to generate revenues seek additional capital for business expansions. Investors purchase shares so that they can reap the short-term rewards of price swings or share in the long-term prosperity of getting in early on a new investment opportunity.
The investment in an IPO is speculative. These companies often have no proven strategies for success and no track record of marketing success or corporate earnings. Many of these companies crash and burn, and only a few endure to become big-time financial success stories. Keep in mind that for every Intel or Microsoft, 50 companies go bankrupt. (Studies show that about 50 percent of IPO firms are in business five years after their initial offerings.) In other words, the success rate of IPOs is one out of every two. Understanding the basics of IPOs, performing fundamental research, and knowing how to be an early shareholder can increase your chances of suc cess. Ameritrade (www.ameritrade.com/education/ html/encyclopedia/ tutorial1/t1_s10.html) provides education about the basics of IPOs. Click the hyperlinks for a short investor tutorial about IPO offerings and investing strategies.
Getting the scoop on IPOs
The following guidelines may help you select a winner out of the thousands of companies that have initial public offerings each year:
Read the prospectus. Read the preliminary prospectus to find out about the company’s expected growth. The red herring (a preliminary prospectus that pro vides information but isn’t an offer to sell the security and doesn’t include any offering prices) includes a description of the issuer’s busi ness, the names and addresses of key corporate officers, the ownership amounts of the key officers, any litigation problems, the company’s cur rent capitalization, and how the company plans to use the new funds from the offering.
Perform fundamental analysis. Evaluate the company’s financial performance by using fundamental analysis, just like you would for any other stock. Fundamental analysis is a form of security valuation that seeks to deter mine the intrinsic value of a stock based on the stock’s underlying eco nomics. You then compare the intrinsic value and the asking price. For more details about how to perform a fundamental analysis, see Article 11.
Check out the company’s management. Examine the backgrounds of the firm’s senior managers. What is their executive management experience and education? Do they have work experience in their current jobs?
Read the mission statement. Investigate the firm’s strategy. Is it realistic? How large is the company’s market? Who is the competition? If the company plans to gain less than 25 percent of the total market, the firm may not be a longterm success.
Investigate the planned use of funds. Determine why raising a certain amount of capital is so critical to the company’s success. If the money is used to pay debt, the company might be headed for problems; using the money for expansion is a positive sign.
Compare IPO prices. Compare expected IPO prices in the red herring with the final prospec tus. If the price is higher in the later prospectus, the underwriters are enthusiastic about the offering. Lower prices indicate a lack of interest by the investment community.
Determine whether it’s your kind of company. Decide whether you want to own stock in the company you’re research ing. Maybe it’s a great financial opportunity, but you have reservations about the product or service. (For example, do you really want to be part owner in a company that kills frogs?)
Estimate your planned holding period. Decide how long you plan to keep the shares. If the IPO is going to be successful, it will be a better long-term investment than short-term investment because IPO stock prices tend to move up or down with the stock market.
Understanding the limitations of IPOs
If your goal is to create massive wealth or to enjoy a comfortable lifestyle, making the most of your money takes time and vigilance. You always need to be on the lookout for new opportunities and new ways to invest your sav ings. To many online investors, an IPO may seem like the perfect way to get in on the ground floor of a great opportunity for high-flying returns. If the IPO you select is going to be a good investment, then with luck, it could pay off over the long term. Your investment will grow as the company expands and becomes profitable. But a high level of risk exists. IPOs are speculative invest ments. Many promising firms go bust. You need to consider the limitations of IPOs. For example:
Many IPOs lose much of their value after the first day of trading.
Many positive-looking IPOs are offered only to the “best” clients of large brokerage firms, pension plans, and institutions. However, you can always gain access to an IPO when it starts trading on the secondary market. (The stock begins trading on the secondary market when an investor purchases it from the investment-banking firm in the primary market and begins to sell it on a stock exchange.) The performances of these stocks are similar to the performances of small cap stocks and are very volatile.
After three to six months, IPOs may underperform some small cap stocks. The source of this problem may be employees selling their shares and forcing the stock price to decline.
After three to six months, the popularity of a strong IPO often fades. Most IPOs go to large institutional buyers, such safe approach to getting in on the IPO of your as banks, pension funds, and mutual funds. choice is to purchase shares in a mutual fund Frequently, traditional brokerages receive a few that has already purchased shares of the IPO. shares for affluent or active investors. To get on Several large mutual funds include IPOs. the preferred customer list, an IPO investor might However, participation in IPOs shouldn’t be the need more than $100,000 invested in his or her only reason you purchase a mutual fund. Before trading account. Some brokerages require bal-making your investment decision, you still need ances as high as $1 million. One way for the do-to carefully read the fund’s prospectus and com it-yourself online investor to catch a potential IPO pare it with other mutual funds and your overall winner is to tap into the up-to-the-minute IPO financial objectives. information that’s available on the Internet
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