The Basics of IPOs: Some Things You Should Know Before Investing

Stock markets with positive momentum can bring on initial public offerings (IPOs) and plenty of hype. Like most new things, it can be easy to get caught up in the excitement, and IPOs are no exception.

Several major companies have filed to go public or are reportedly considering the move, so it may be as good a time as ever to learn some basics of IPOs. IPOs were once available mainly to institutional investors, but today many retail investors have the same opportunities to invest in newly public companies.

When it comes to investing in IPOs, investors should consider keeping a cautious outlook. Many times in recent years, an IPO with a lot of publicity and hype cratered soon after its opening day. Sometimes investors confuse a company brand with its business. In other words, you may love the product, but that doesn’t necessarily mean you have to love the stock, too.

One potential problem with IPOs is that many investors might rush in. It might be worth waiting to see what the stocks do. Or, if you do jump on an IPO, you might want to consider buying shares in partial increments rather than going all in at once. People can be excited to invest in these companies, but it’s good to keep the potential downside in mind.

Just as with any other investment, it’s important to do your own homework and review some IPO basics so that education, not hype, drives your decision-making.

The Basics of IPOs

So why do companies go public? Private companies go public for a variety of reasons: to try to maximize shareholder value, to raise capital to invest in the business, or to use the shares as currency for a merger or acquisition. IPOs are also one of many ways venture capital and private equity investors exit their stakes in a company.

The number of companies filing to go public tends to accelerate during strong markets, but there are many factors that go into a company’s decision about when, and if, they will file to go public. In 2021, proceeds from U.S. IPO’s have reached $89 billion, a 23% jump from the same period last year, according to Renaissance Capital (an IPO research firm). 

What Drives Demand in an IPO?

So just what makes for an in-demand IPO? The answer to that question is highly subjective and difficult to determine before the stock actually starts trading. That’s because a company filing to go public is largely an unknown entity. Sure, a company must file a prospectus with securities regulators and supply investors with financial information before listing. But without any trading history on public markets, or quarterly financial results, determining an IPO’s prospects is more art than science. Still, there are a few places to turn for more information.

First, check whether established, reputable banks are underwriting the IPO. You can gather information about the underwriters by checking the company’s pre-IPO regulatory filings.

Next, analyze publicly traded competitors and how those shares are performing. If stocks of companies in the same industry are trending higher, it could suggest the IPO might do well. It’s also possible these companies are already entrenched in their respective sectors and a newcomer could struggle to be successful. Conversely, if competing stocks are in a bear market, then the IPO could decline with the rest of the sector.

Debut Time: The First Day of Trading

One of the most important aspects of an IPO is the opening price—where the stock begins its exchange-listed life on its first day of trading.

Accurately pricing an IPO is a challenge even for the investment banks that have been doing this for years. Naturally, the company holding the IPO wants a high price, while investors prefer something lower. It’s up to the banks to find the middle ground. Sometimes they nail it and sometimes they miss badly.

Generally, a stock that falls below its opening level may require further “price discovery,” meaning it could drop further until it reaches a point where it’s considered fairly valued. Alternatively, when a stock jumps above its opening price, it’s sometimes perceived as a bullish sign that investors want more and are willing to pay up.

Waiting Until the Stock Starts Trading

In many cases, it may be prudent to just wait until after a stock starts trading—in other words, let the dust settle. Remember, once a stock is public, it’s out in the market spotlight with its peers. The days, weeks, and months following an IPO will typically reveal whether it was priced well and what kind of growth prospects might lie ahead.

Some simple trading logic can be built around an IPO. Investors might consider simply waiting for a day, or a few days or longer, after the IPO starts trading on the open market. They can then determine potential entry and exit points based on their observations and understanding of technical analysis, as well as what’s appropriate for their risk tolerance.

Of course, the drawback of waiting for an IPO to start trading could mean missing out on a possible initial pop from the offering price. But guess what? A pop could be a pop up or a pop down. Not all IPOs pop. Some just fizzle.

Before investing in an Initial Public Offering, be sure that you are fully aware of the risks involved with this type of investing. There are a variety of risk factors typically associated with investing in new issue securities, any one of which may have a material and adverse effect on the price of the issuer’s common stock. For a review of some of the more significant factors and special risks related to IPOs, we urge you to read our Risk Disclosure Statement.