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The Basics of IPOs: Some Things You Should Know

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February 21, 2017
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Record stock markets can bring on initial public offerings (IPOs) and plenty of hype. Like most new things, it can be easy to get caught up in it all and IPOs are no exception. Now may be as good a time as ever to learn some basics of IPOs to avoid getting burned by the sizzle.

Some of the companies that speculators think could file in 2017 appear to have lofty valuations, if you ask some analysts, who note that some of these companies are still operating at a loss. Depending on the industry, other metrics might be more important when valuing the company than net income alone. For example, investors might be looking at daily and monthly active user growth rates for a social media company. It’s important to do your own homework on specific IPOs, and also is a good idea to review some general IPO ins and outs so that education, not hype, drives your decision-making.

Nuts And Bolts

IPOs tend to accelerate during strong markets, but there are many factors that go into a company’s decision of when, and if, they will file an initial public offering. After peaking at 363 new offerings in 2014, the number of IPOs declined to only 128 in 2016. Considering there were 104 IPOs in 2008 and 118 IPOs in 2009 during the height of the financial crisis, 2016 was a pretty quiet year as the three major U.S. indices hit new all-time highs. IPOs in 2017 have been off to a slow start, but it’s very early in the year.

So why do companies go public? Private companies go public for a variety of reasons: to “maximize shareholder value”, to raise capital to invest and grow the business, or, possibly, 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 the company.

For The Early Birds

Brokers must be part of the initial offering, and not every broker has access to every IPO. Even if your broker is participating, it can be hard to get IPO shares. If you’re a TD Ameritrade client, details on IPOs in the pipeline are accessible to with just a few clicks (see figure 1).

FIGURE 1: MAKING A DEBUT.

Expected IPO prices and other details (yellow circle) for specific dates are available on tdameritrade.com. To access the Calendar, log in to your account, go to My Account: Overview, click the Calendar tab, and select IPOs from the Event type drop-down (yellow arrows). Source: TD Ameritrade. For illustrative purposes only.

Another tactic: Identify private-equity firms and big banks that underwrite IPOs and/or provide early-stage funding. Typically, these underwriters get a stake in the newly public company for their efforts, which can pay off down the road if the IPO is priced correctly and performs well. If the underwriter is publicly traded, consider the shares as a potential proxy for the eventual IPO.

At this point, 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 in any meaningful quantity because of high demand.

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 an IPO 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, handicapping an IPO’s prospects is more art than science. Still, there are a few places to turn for guidance.

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. Of course, there’s no guarantee these banks will always deliver the best IPOs, but there’s a better chance of success if at least some big names are involved. 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 better 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.

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 ETFs. For illustrative purposes only.

Debut Time

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—that nice, round number where the stock begins its exchange-listed life on its first day of trading. Pay close attention to how the new stock trades in the days and weeks following the IPO.

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, which is sometimes perceived to be a bullish sign that investors want more and are willing to pay up.

One more consideration: price. Accurately pricing an IPO is a challenge even for the investment banks who’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 middle ground. Sometimes they nail it, but sometimes they miss, badly.

Ex-Post Facto

In many cases, it may be best 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 brethren. The days, weeks, and months following an IPO will reveal whether it was priced well and what kind of growth prospects lay 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. You can then determine potential entry and exit points based on your observations and understanding of technical analysis, as well as what’s appropriate for your risk tolerance.

Of course, the drawback of waiting for an IPO to start trading could mean you miss 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.