Remember that crazy frenzy that took place when Facebook announced its IPO back in 2012? Called by media pundits a ‘cultural touchstone’, the Facebook IPO was one of the biggest in technology and reached a peak market capitalization of over $104 billion. It set another record for trading volume of an IPO at 460 million shares traded on opening day. However, by the end of opening day, Facebook’s IPO was labeled a financial disappointment. Stock price closed at only $0.23 above the IPO price. Bloomberg estimates that retail investors lost approximately $630 million on Facebook stock since its debut. Facebook’s IPO tells us a few things about an IPO. IPOs are rarely so clear-cut. Even a massive company such as Facebook made huge losses. The implications of an IPO are also long-term, possibly involving things such as damaged reputation, investor pessimism, and, in the case of Facebook, more than 40 lawsuits filed. So what exactly is an IPO? Is it good or bad? And how would you go about investing in an IPO? In this article we lay down the fundamentals of an IPO and how the smart investor uses IPOs to make his wallet grow.

IPO

An IPO stands for Initial Public Offering. It is the process by which a company sells shares of its stock on a securities exchange (e.g. NASDAQ, NYSE, SGX) for the first time. Thus, a private company becomes a public company. Take note that the company itself will never pay investors who purchase stock from an IPO back. Thus, they invest at their own risk. After an IPO, money passes between public investors. The IPO market is also extremely volatile, more so than normal stocks. Be prepared for a rough ride, but keep your eye on the longer term goal. In general, the process of an IPO goes like this: company XYZ will approach an investment bank (e.g. JP Morgan, Goldman Sachs) to underwrite their offer. These investment banks help XYZ to settle on a price for their IPO through conducting financial valuations of the company, choosing which security exchange, and agree to sell and distribute XYZ’s shares to public investors. Should they be unable to find enough investors, a commitment is usually made by the investment bank to hold onto these shares themselves, instead of discounting the price and dumping them on the market, which could lead to an overall fall in market price. Underwriting an IPO is no small risk, so investment banks usually form a syndicate with other investment banks to underwrite the offer together and share the risk. The main investment bank becomes the lead underwriter.

What to look for in an IPO

Here are 5 things to keep in mind:

The Market

IPOs don’t impact the markets in as big a way as even the Facebook IPO might suggest. IPOs follow the market just as any other stock does. What does this mean? It means that if the market is doing well, chances are your IPO will also do well. Of course, there are exceptions to this rule, but in general, it’s unwise to take the jump when the markets are looking a little iffy.

The Industry

How well an IPO does will also be dependent on the optimism and general good sentiment towards the industry. Expect that some spillover of this goodwill to infect the IPO as well, making IPOs in ‘hot’ sectors generally a little more insulated from any market turmoil. Again, there are exceptions to this rule, but it’s still a good rule to keep in mind. Check out this article for some of 2014’s promising sectors.

Research & Information

IPOs will require a lot more analysis and research than normal stocks. One reason is that prior to an IPO, a private company has no obligation to release any of their financial information to the public. When a company approaches its IPO, all this information, compiled into a document called a prospectus, becomes public affair. The prospectus is an important document that you should definitely analyse. It offers information on the company’s risks and opportunities, as well as where it’s headed to in the future. For example, a company that mentions that capital raised from the IPO will be dedicated to research and development, or market expansion is much better than a company who indicates that this capital will be going towards repaying their loans. However, because the company and the underwriter are attempting to build up hype and enthusiasm for the IPO, you can expect a lot of inherent bias to be in this document, such as inflated earnings forecasts. Furthermore, because the company hasn’t been under the scrutiny of analysts and financial experts for the better part of its existence, objective 3^rd party opinions will be difficult to come across. So always remember to do as much research as you can! Look at the company and its competitors, look at the industry, check out past press releases and so on. Research beyond the prospectus might uncover some discrepancies or suspicious cracks in a company’s fundamentals that could save you from losses.

The Underwriter

So far we’ve mentioned that investment banks usually underwrite the risk for an IPO. While J.P. Morgan, Morgan Stanley and Goldman Sachs are all big and reputable names, there are smaller investment houses that offer underwriting services as well. There are perks and downsides to smaller investment houses. The perks are that with big firms like Goldman Sachs, they usually only push the stock to their long-standing, established and very wealthy clients and customers. Other than mutual funds or brokerage houses, the only individual investors to get in on a piece of the action are very High Net Worth Individuals with an established relationship with the investment bank. With smaller investment houses, even if you’re not as practiced or wealthy as these individuals, you might still be able to purchase some IPO shares because of their smaller client base. On the flip side, big investment banks like Goldman have big reputations and big pockets. They can generally afford to be pickier and more selective with who they choose to underwrite, meaning they generally, like you, wish to choose a quality company that promises profits from an IPO. Smaller investment houses are less established. Because they need to rack up some ‘experience points’, if you will, to grow bigger, they’re more likely to underwrite any company that comes to them, even if sometimes the company isn’t genuinely promising. This is the risk with purchasing shares with smaller investment houses. Again, this isn’t always the case, and goes back to point number 3: always do your research before purchasing!!!

The Lock-Up Period

This is a legally binding specified period between the underwriter and the company that prohibits them from selling any shares of the company they own until the period expires. Companies and underwriters do this to prevent the flooding of the market with too much stock, because excessive supply could cause the price of the stock to fall. However, being patient and waiting till the end of the lock-up period has its benefits. After the lock-up period, company employees and insiders can sell any shares they’re holding. If you see these people rushing to sell their shares once the period expires, it could indicate that insiders are pessimistic about the future of the company, which could be a signal to stay away. But if you see that insiders are choosing to hold their stock, then the future is likely brighter, and you can then make a more informed choice to invest.

Proceed With Caution

IPOs are often accompanied by a lot of hype and fervor, even more so than your normal stocks, which makes the IPO market so much more sensitive to investor sentiment. It might seem extremely tempting to jump into an IPO as quickly as possible, especially if the name is one that is big and exciting like Facebook. Stop right there! Exercise some caution and think about the above rules before taking the plunge, and you’ll be less likely to find yourself lamenting your losses. Also remember to look out for our next article on which IPOs in 2014 to keep an eye on! Happy trading!