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

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June 27, 2017
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Stock markets at record highs 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. As the number of companies filing to go public has increased in recent months, it may be as good a time as ever to learn some basics of IPOs to avoid getting burned by a new offering.

Some of the companies that speculators think might file in the remainder of 2017 and 2018 appear to have lofty valuations, according to some analysts, who have noted that some of these companies are still operating at a loss. Just like with any other investment, it’s important to do your own homework and review some of the general ins and outs of IPOs 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 “maximize shareholder value”, raise capital to invest and grow the business, or, possibly, 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 the company.

The number of companies filing to go public tends to accelerate during strong markets, however there are many factors that go into a company’s decision of when, and if, they will file to go public. After peaking at 363 new offerings in 2014, the number of IPOs declined to only 128 in 2016. Considering there were 104 in 2008 and 118 in 2009 during the height of the financial crisis, 2016 was a pretty quiet year. 2017 got off to a slower start, but it has accelerated in recent months with 65 IPOs so far this year as of June 25, according to IPOScoop.

Buying an IPO

First things first, your broker must be part of the initial offering, and not every broker has access to all of them. Even if your broker is participating, it can still be difficult to get the new shares and you must meet certain requirements pertaining to experience, risk tolerance, income and/or investable assets. If you’re a TD Ameritrade client, details on upcoming IPOs are accessible with just a few clicks (see figure 1).

TD Ameritrade Initial Public Offering (IPO) Calendar

FIGURE 1: MAKING A DEBUT.

Expected IPO pricing and other details (yellow circle) are available to TD Ameritrade clients on tdameritrade.com. To access the Calendar, log in to your account, go to My Account: Overview, click the Calendar tab, and select Equity IPOs (yellow arrows). Source: TD Ameritrade. For illustrative purposes only.

At this point, if you’re able to access the IPO and the company meets your investment criteria, there are several items to consider: the overall offering size, how many shares are available, and the general level of demand among investors. Shares of some IPOs—generally high-profile companies with plenty of attention in the financial press—can be difficult to acquire because of high demand.

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 the 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. That list includes, but is not limited to, Goldman Sachs, J.P. Morgan, Morgan Stanley, Barclays, Bank of America Merrill Lynch, Credit Suisse, Citigroup, Deutsche Bank, and UBS. Checking financial media coverage, or the company’s pre-IPO regulatory filings, is one place to gather information about the underwriters.

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 a chance 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.

There are some ways to assess the collective performance of IPOs, such as through indexes calculated by Renaissance Capital LLC; one recent reading indicated shares of freshly-minted companies have underperformed the broader market since mid to late 2015 (see figure 2). Additionally, there are a number of other types of investment products you could consider without directly obtaining shares in an IPO. For example, some larger mutual funds and exchange-traded funds may be able to obtain a large number of shares in initial public offerings that individual investors would have a hard time accessing.

Reniassance Capital IPO Index Performance

FIGURE 2: COOLING OFF?

A U.S. IPO index compiled by Renaissance Capital LLC has underperformed compared to the S&P 500 (SPX) since mid to late 2015. Source: Renaissance Capital - manager of IPO-focused ETFsFor illustrative purposes only.

Debut Time: The First Day of Trading

It’s long been said that it’s not how you start that’s the most important thing. It’s how you finish. That’s not necessarily the case with an IPO. 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’ve 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 is sometimes perceived to be 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 harsh, unforgiving 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 can simply wait for a day, or a few days, after the IPO. 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 the initial pop from the offering price. But, guess what? Not all IPOs pop. Some just fizzle.

For more information about IPOs check out TD Ameritrade's Investment Products page.

Editor's Note: This article is an update of the original The ABCs of IPOs published on July 1, 2014.

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