How do IPOs work? The basics
This has been a big year for companies going public. But what is an IPO, and what should investors be looking out for?
Initial public offering – what is it?
An initial public offering is where a privately-owned company makes its shares available to be traded on the stock market for the first time. If successful, opening share ownership to the general public allows the firm to raise large amounts of capital quickly.
The first IPO occurred in 1602 when the Dutch East India Company went public, raising 6.5 million guilders. 2019 has seen a slew of IPOs hit the market with volumes not seen since the dot-com boom. However, with some high-profile flops making headlines, what factors influence a successful IPO?
How IPOs are valued
The opening value of a company new to the market, i.e. its initial share price when it starts trading, is simply determined by the level of demand among buyers. Demand can be driven by several components, and sometimes business fundamentals have nothing to do with it:
IPOs fare much better in bull markets, particularly when credit is cheap and the system is awash with money. Equally, IPOs tend to be thinner on the ground when the reverse is true, and investors are more cautious.
The level of hype behind a business or industry can cause investors to overlook profit and loss accounts entirely. If a company can market itself as a legitimate disruptor, money will follow it as speculators become motivated by fear of missing out.
3. Comparable companies
What are shares for similar companies in the industry selling at? The share price of industry comparables will influence what a company can expect from its stock market flotation.
4. Growth projection
The whole point of going public in the first place is raising capital to fund expansion. A company’s stock market value will be influenced by the strength of that company’s plan and prospects for growth.
It is sometimes said that investors back a person, not a business. It is not uncommon for large companies to be led by a charismatic founder who can sell his or her vision of the future to investors and the market. The quality of the management team can also be important.
Companies that post healthy revenues in the years building up to an IPO should traditionally expect a premium value compared to their industry peers.
Do your homework!
A shrewd investor will take a holistic view of a company’s attributes rather than get carried away by hype when demand is high. Taking the time to read a firm’s financial reports and consider its fundamentals could spare you a nasty surprise down the road.
Take Webvan.com. A first-mover in the grocery home delivery market, Webvan.com raised $375 million when it went public in 1997. Unfortunately, its business plan was shaky, its overheads were enormous, and its services underpriced. It filed for bankruptcy in 2001.
Some volatility in the marketplace is inevitable – but if you believe in the fundamentals of a company, then its stock is likely to rebound in the medium to long term. Look at Facebook: its IPO was a disaster, with shares plummeting by the end of the day’s trading. Today the company is performing well and those investors who held on to their shares will have seen a good return.