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The Exciting World of IPOs
An initial public offering (IPO) is the first time that the stock of a private company is offered to the public. This gives individual and institutional investors the opportunity to own a part of the company. Can you imagine how thrilling this is? Why? Because IPOs are potentially huge opportunities for making money- this is why such excitement generally surrounds them. When an IPO is in great demand, investors find themselves fighting to get their share of the pie. Many of them are oversubscribed which means that most people get less than they want. This high demand and low supply usually causes the price to rise. It is hard to match the excitement of a successful IPO for an investment professional or a professional investor.
There are many unsuccessful IPO’s too, and a failure would be defined by one of two things: firstly, if the IPO is undersubscribed that means that they don’t get the minimum required to “go public” or the price may fall significantly soon after the offering and the prices stay permanently below the IPO price. There is a danger for other companies wishing to “go public” soon after a failed IPO. When investors become too risk averse, they, as a group, periodically shun other IPOs. In a real way, the company may get tarred with the same brush, as they say. However, the opposite can occur, as a string of successful IPOs may get investors so carried away, that they don’t even bother to examine the companies too carefully.
Buying on Hype
The vast majority of investors will buy based on hype. This is not always bad, because the hype is usually based on the estimated demand or excitement surrounding the issue. It may be driven by a few knowledgeable investors who are confident in the company’s prospects spreading the good news to their friends! Additionally, when a company has strong growth prospects, the stock is likely to keep appreciating in price, especially when the reported earnings are good. However, if it is empty hype, the price will usually fall as soon as the stock is listed.
Factors that aid in an IPO’s success
Name recognition is a big help to companies. When a company is a well-known household name, with products that are used by investors and financial professionals alike, it adds well needed comfort to potential investors.
History of making money. This is really speaking to the profitability of the business, i.e. are the profits growing in the right direction. Are they fairly consistent? Are revenues growing each year, and is the company managing their expenses prudently? These are some of the things that potential investors analyze before investing.
Strong growth prospects. When management communicates the path expected for the company and it sounds credible and very positive, investors can buy into that vision. This tends to lead to higher prices based on expected future income.
Management. Unfortunately, history is replete with companies making money with strong growth prospects but the owners may be funneling the money into their own pockets. You can track the growth of the capital since if the company’s profits are increasing, then the capital should be growing. If this is not the case, something strange may be up. It is very important that the investors have confidence in the management of the company, as this can make or break the business.
Price/Earnings (P/E) ratio: This is one of the most favoured metrics in assessing difference companies. In its simplest form, it is really comparing the IPO price to the earnings of the company. The company sets this price, which means it may or may not be reasonably priced. If investors feel that it is too expensive-they may shun the offering. If it is considerably fairly priced, i.e. similar to comparable market offerings, then there may be some upside, but it is likely to be limited.
Two things come to mind based on past experience. One factor is that the timeliness of the information can be very short. It affects investors in several ways, including your liquidity may be tied up in other investments, and you may not be able to liquidate in time to participate. In addition, the information may be too much to assimilate in a short time therefore you may feel pressured to participate without fully apprising yourself of the company’s financial standing. This is the time to request other companies’ analyses of the IPO so that you can save some time.
Finally, the question on most investors mind is: how long should I hold this investment? Of course, most people want to “flip it”, i.e. sell it soon after assuming that the price rises quickly. However, there is no guarantee that this will materialize and it is dependent on having enough investors willing to buy at elevated prices. If everyone wants to sell and no one wants to buy, the price will be forced downwards.
IPOs present lots of opportunity and the attendant challenges, and they are part of a balanced portfolio. It is definitely worth the time to understand how they operate and how you can profit from them. However, don’t forget to balance the risks and the potential returns.
Yanique Leiba-Ebanks, CFA, FRM is the AVP, Pensions & Portfolio Investments at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: firstname.lastname@example.org
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