Out of all the components of investing, initial public offerings are arguably the most exciting. A company that goes public is full of promise without any of the baggage that plagues other stocks. The hype is high for an IPO, and the future always looks bright. Investors often want to get in as early as possible when a company looks like an attractive investment idea, and that pent-up demand usually raises share prices the day the company’s stock starts being traded.
As exciting as an IPO can be — remember the massive hype when Facebook and Google went public — they’re never sure-fire investments. In a way, they’re almost like gambling. There’s way more data to make a smart decision when it comes to long-established companies. While financial data is available for companies pursuing an IPO, investors are flying somewhat blind.
With that in mind, IPOs can be both a great and terrible investment depending on the company. If you’re considering getting in at the ground floor of a company that’s going public, here are some things to consider.
An IPO Explained
An IPO is the first time a company makes shares publicly available. This is done with the help of an underwriter, which is often a large financial institution. This financial institution sells the IPO share to willing buyers. A price is set based on how much they think people are willing to buy. If demand is high, prices can go up even before the company’s shares begin publicly trading.
IPOs happen regularly but not too often. In the past five years, an average of more than a dozen companies annually went public.
Research shows stocks often perform exceptionally well on their first day of public trading. In 2013, for instance, six IPOs doubled their initial offering price on the first day. That’s an incredible return and shows exactly why IPOs generate so much interest.
With such returns, an IPO sounds like a no brainer. The problem, however, is that those gains are rarely sustained. A study from a Wharton School professor looked at 9,000 stocks that went public since 1968 and tracked their performance until the end of 2003. Four out of five of these companies underperformed the market by around 2 percent annually.
That’s a weak return that should give investors pause. For all the hype IPOs receive, the evidence shows they’re often not as valuable as other companies. There are, however, many winning IPOs that net savvy investors a lot of money. The problem is it’s difficult for casual investors to actually obtain shares during an IPO.
Finding an In
When an underwriter is looking to sell shares of an IPO to investors, it’s often challenging for smaller investors to get in on the action. The financial institution typically sells to big-time investors and their existing customers. In many cases, you need to know someone in order to buy anything before trading begins. Even big buyers can have difficulty obtaining shares if the demand is high enough.
It’s unfortunate small-time investors are often squeezed out of the process, but in some cases it could be for the better. While those first-day gains for IPOs are impressive, the historical returns are often underwhelming.
Picking a Winner
You might have a lot of success assuming you have the means to get in on an IPO. Like with the lottery, people tend to focus on the big winners rather than the many losers. Google, now known as Alphabet, had an IPO price of $85 and has since increased by more than 1,200 percent. Companies like that are rare but do come around every now and then. If you can get in, then go for it. Most likely, however, you’ll be stuck on the sidelines.