Investing in IPOs

The price of any financial asset traded on the stock market is determined by the age-old forces of supply and demand. Regarding initial public offerings (IPO) that have no trading history the question may arise as to how an analyst may value an IPO share price. There are at least two schools of thought regarding investing in IPOs, one being that the lack of historical information on share price performance provides a buying opportunity, and the other being that because IPOs have not yet been tested on the market, they present a higher risk factor.

While a financial asset may not have built up a trading record, this does not mean that it hasn’t been analyzed. Buying IPOs can be very rewarding, and some stock market investors specialize in these new arrivals on the market. Some of the factors taken into account when deciding whether to invest in IPOs include investigating: why the company concerned has elected to go public; what the company plans to do with the money raised by the IPO; the company’s operating track-record; the company’s market-share in relation to its competitors; how extensive the market for its product/service is; what level of profitability the company is aiming for; and what growth prospects does the company envisage. With regard to the company’s management team, analysts would want to know if any of the people involved have experience in managing a publicly traded company and if they are qualified to do so. Also, if management owns any shares in the business this would be an indication that they have confidence in the success of going public.

The majority of this information is not difficult to obtain, as it forms part of the S-1 form required by the Securities and Exchange Commission (SEC) when a company applies to list on a stock exchange. Using the information on the S-1 form, an analyst will be able to determine a reasonable valuation for the company, which would then be divided by the number of shares on offer to obtain a reasonable price for the stock. This could be cross-checked by comparing the IPO stock price to the stock price of a similar company that is already listed. Using this calculated stock figure, if the stock is trading at a lower price than they believe it to be worth, investors will buy the stock to sell when it reaches what they believe to be a fair price. Or, if the stock is trading above what is believed to be a fair price, investors may choose not to invest, or to short sell the overpriced stock in anticipation of a future market correction.