What is an IPO, and Should I invest in it? (Video)

With all the news around the Robinhood drama and the possibility of the firm going public, the IPO market seems to be gaining recognition.  In fact, 2020 was an unprecedented year for IPOs reminiscent of the 1990s.  What is an IPO, and should consumers invest in them?   

Let us Explain IPO’s.

IPO’s or Initial Public Offerings are the way privately owned companies become publicly owned by offering stock shares in the company to the public.  Owners of the company are motivated to do this for a few reasons, one reason is it makes their ownership in their company more liquid since they can now sell their shares on the stock market and reinvest in other things enabling them to diversify their net worth. Another reason they do it is to help the growth of the firm, by selling shares of the firm in the IPO they get access to outside capital from investors. When companies go public and offer their shares, they have several regulatory hurdles to overcome with the Securities and Exchange Commission, etc. They also typically will hire a large investment banking firm such as Goldman Sachs to assist them with the public offering including pricing it. After the iPO is issued it is now available to be traded on a stock exchange.

Many investors are excited by IPO’s since it is the first time, they can invest in what they think could be a winning company. It is important to understand though that for the original owners and founders of the company one of their biggest goals is to cash out part of their value in the company therefore the shares are priced to benefit them and 

Should Investors invest in IPOS?

Investors should be careful in considering IPO’s since their price has been set by analysts, investment bankers, and the private owners of the company, all with a clear conflict of interest with public purchasers. Those people want to maximize the price so they can make the most commission for the investment bankers and for owners the greatest value for their ownership. The pricing of the shares once they hit the market now suddenly will be priced more according to what outsiders with no conflict feel the company is worth. We caution you though that many shares take a huge jump in value after the IPO since there tends to be irrational excitement over it by the public and that excitement leads to a supply and demand issue where demand far exceeds the supply of shares issued driving up the price. We have seen many IPO’s drop in price in the weeks and months after the IPO[1]. One that comes to mind was the IPO for Red Hat, a company that was selling “free” software, Linux[2]

 Overall, underwriters have difficulty pricing an IPO because there is no current price available, naturally, they want to price it as high as possible since they do not want the issuer to “leave money on the table”.  An IPO is not always a good investment, Google and Amazon were great investments, Groupon and pets.com not so much.

 The usual customers that purchase IPO stocks are institutional investors, other banks, and firms, who buy large blocks of stocks, those institutions, in turn, sell the shares to individuals.  The typical price behavior for IPO stocks exhibits a characteristic shape; during the initial IPO when the investment bank makes a profit on its shares of stock the price rises and sometimes doubles or triples, then the stock declines.  It only finds its appropriate valuation once the company has demonstrated the likelihood of profits.

We saw this shape with profitable companies (like Google) and unprofitable companies (like Groupon). The Google IPO opened on Aug. 19, 2004 at $85/share and closed the first day at $100.34.  Ten years later, on August 21,2014 the stock was trading at $583.71 and as of yesterday’s close it is at $2086.48.   

 On the other hand, Groupon IPO opened on November 4th, 2011 at $28/share and closed at $26.11 the first day.  Ten years later, November 6, 2020 it was trading at $22.32/share. 

 In both cases there was an initial bump in the price of the stock and then the price came down.  Groupon kept declining whereas Google found the appropriate valuation based upon its is expected profits.  Long-term individual investors make money from their shares ONLY IF the company is profitable.  

So What Should You Do?

Ignore the hype! The lesson in all of this is that usually there is no reason to be first in the purchase.  Let the stock find its value, once it is clear the company will turn a profit then it is time to wade in. always stay well diversified and never let any stock represent more that 2-3% of your portfolio. 

[1] Here is a list of some: https://blog.cheapism.com/companies-going-public-flop-17124/

[2] https://www.zdnet.com/article/top-red-hat-ipo-sees-share-price-triple/