Prior to listing a stock for sale on a public exchange, companies go through a rigorous process of preparation and compliance.
In addition to providing the SEC and the public a detailed prospectus about their team, background and finances, they must come up with a suggested starting price for each share they plan to sell in their IPO.
This price then creates an IPO valuation for the company. There are a variety of factors and steps which are used to determine the IPO price.
Related: What is considered a good return on investment?
What is an IPO?
When a privately-owned company begins to sell shares of stock to the public, they hold an initial public offering, or IPO. This is also called “going public.” Prior to an IPO, companies are owned by the founders, employees and early investors such as venture capitalists and angel investors.
An IPO can help a company to bring in significant funds for expansion, and can also be great publicity.
However, the process is time-consuming and expensive, and once a company has gone public, it faces new challenges such as increased scrutiny and the need to please shareholders.
There are also pros and cons to investing in IPOs, and various factors to assess when considering each stock.
Why do companies choose to go public?
Less than 1% of businesses in the U.S. go public. Holding an IPO is a huge and risky undertaking, but can create significant value for a company. The main reason companies choose to go public is to raise money.
Some even choose to hold an IPO when they are close to going bankrupt. General Motors brought in $20.1 billion through their 2010 IPO, after filing for bankruptcy one year earlier.
Other reasons companies go public are to gain media attention, to grow a broad base of financial supporters and to please venture capitalist who helped fund the company in its early stages.
Bringing in public investment benefits the business, but it also benefits early investors and employees. Those who have invested time and money in a company can sell their shares following an IPO.
When an employee joins a company, sometimes they are granted stock as part of their employment package. They don’t own this stock right away, it is given to them over a number of months or years.
This is called a vesting period. A vesting structure incentivizes employees to stay with a company and protects the company’s holdings should an employee quit or be fired.
Usually, employees must wait to sell their vested stock until the end of a “lock-up period” of a number of months after an IPO. In many cases, IPOs raise millions and even billions of dollars.
IPO price
The rules of supply and demand which apply to most products also apply to stocks. As an investor, what are you willing to pay for each share of a company when it decides to go public?
When a company decides to hold an IPO, they work with an investment bank to come up with the price and do most of the underwriting.
Each bank has a slightly different way of determining the IPO price, but the factors they consider are essentially the same. A few of these factors include:
• Why has the company decided to go public?
• What is the current status of the market?
• Who are the company’s competitors?
• What are the company’s assets?
• How much has been invested in the company and by whom?
• What is the history of the company and its team?
• What are the company’s prospects for growth?
The process of IPO pricing goes like this:
Prior to an IPO, the ownership of Company X is divided into N equal shares. The existing owners each own a certain number of these shares. These owners include the founders, early employees and any venture capitalist and angel investors who already own a stake in Company X.
When Company X decides to go public, the existing owners are selling off a portion of the company to investors in order to raise capital. The money raised in the IPO goes into the company’s bank account, and the percentage of ownership of each of the initial owners goes down.
To create a balance in this tradeoff that makes both existing and new owners of the company happy, the company must decide how many new shares to issue, and the price they plan to sell each share for in the IPO.
For example:
• Company X decides to issue M new shares
• Each share is sold for $x
• Company X adds $xM to its bank account
• Each share bought by the public is 1 / (N + M) of Company X
• Original owners of Company X have their ownership reduced by the factor N / (N + M)
The company’s executives and their investment bank first come up with M by determining how much money they hope to raise and how much of the company they are willing to give up.
Once they decide upon M, they reach out to institutional investors to start asking them how many shares they are interested in buying. Institutional investors include hedge funds, mutual funds, high net worth individuals and pension funds in good standing with the investment bank.
These investors come up with estimates about the price based on their own analyses, and rumors begin to circulate about the IPO price.
Days before the IPO, the institutional investors place requests for how many shares they actually want to purchase. Company X then sets the price for the IPO, and they know exactly how much money they will raise.
The underwriting investment bank goes through the complex process of figuring out the allocation of all the shares to the institutional investors. They want to create a balance of different types of investors, and they have knowledge about each of the investors which factors into the allocations.
When the public IPO market opens, the institutional investors hold all the shares, and orders start coming in from retail investors. Unfortunately for the at-home retail investor such as yourself, it can be nearly impossible to buy a stock at its IPO price.
Instead, retail investors often buy at a 10-70% markup, although some companies have been known to trade below their IPO price on the first day. The investment bank for Company X takes a look at all the incoming orders, which may be either buy or sell orders, and reports the predominant price.
They then go through a process of price discovery to determine what the opening price will be. The goal is to have the maximum number of trades be executed from all the placed orders. At Nasdaq, this is done electronically, while at the NYSE it’s done by people.
When they set the price they input all the existing orders, the opening IPO price is now set, and the trading day continues.
In an ideal situation for the company and the underwriters, the closing price of the stock on opening day is fairly close to the opening price. This means the shares are priced accurately for what investors are willing to pay for them.
However, the IPO price isn’t necessarily a good indicator of the value of a stock. Broader market interest in the stock is impossible to plan for, and IPO conditions differ from the long term presence of the company in the market.
You can determine the value of shares sold using the IPO price formula of the number of shares sold divided by the total amount of capital paid in. These numbers can be found in the company’s prospectus document.
This book value is a more accurate valuation than the hyped-up IPO debut price. One of the goals of an IPO is to gain positive media and investor attention, so companies hope to see immediate increases when their stock debuts. IPOs are generally priced with a goal of going up or “popping” 15-30% on opening day.
This ‘discount’ also acts as a cushion to protect the stock from immediately falling in the weeks after the IPO. Ideally, the stock holds its value until the company reports its first-quarter earnings.
Media outlets can also tend towards certain biases when covering upcoming IPOs. This is why it’s important to determine your own criteria for building your investment portfolio and to do your own due diligence. Just because another investor is willing to pay a certain price for a share doesn’t mean you should.
Examples of stocks which declined after IPO
Highly talked about IPOs have disappointed in their opening weeks at the markets. This may be because investors feel these companies are overvalued and don’t want to risk putting money into them when they haven’t yet shown a profit.
It also isn’t uncommon in the world of tech IPOs. Data from Dealogic shows that since 2010, around ¼ of IPOS in the U.S. have seen losses after their first day.
This is both costly and embarrassing since so many months of planning go into holding an IPO. Zoom had one of the most successful IPO of 2019, having gained 120% in its first two weeks on the market. It’s also the only profitable company out of the recent big-name IPOs.
Stock increases after IPO
It can take time for a stock to increase following an IPO, so the initial sale isn’t necessarily an indicator of long term success or failure. The frenzy of the sale doesn’t always result in an immediate rise, but the influx of new capital allows the company to grow.
New hires and expanded resources bring results a number of months, or even years, later. Both Facebook and Square’s stocks experienced tumultuous action for about 14 months before seeing a steadier climb.
As an investor, looking for companies that have a solid team and business plan, rather than just hype and a high valuation, can result in long term portfolio growth.
How to invest in IPOs
As you can see, IPOs can be very volatile. Knowing when to buy stocks is a crucial part of building a strong portfolio, as is keeping a long term perspective.
Although there is potential for significant returns, investors can also see severe losses in the weeks and months after a company goes public. Aside from researching a company before deciding to invest in it, there are other ways to mitigate risk.
Rather than investing right away, you can wait a quarter or six months to see how a company’s stock fluctuates following the IPO, and then decide whether to invest. Stocks can often fall to form a base price before beginning to rise again. Or you can just invest a small amount at first and add more later.
You can also expose yourself to a broad portfolio of new IPO stocks through an ETF. ETFs offer a weighted balance of stocks and are adjusted over time. By diversifying your portfolio you benefit from any standout successes while avoiding huge losses.
Ready, set, invest!
IPOs are all over the news for a reason, it’s exciting when a company opens up to public investment. If you’re a newer investor, it can be challenging to know when and how to add new IPO stocks to your portfolio.
Learn more:
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
External Websites: The information and analysis provided through hyperlinks to third party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.
Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
IPOs: Investing early in IPO stock involves substantial risk of loss. The decision to invest should always be made as part of a comprehensive financial plan taking individual circumstances and risk appetites into account.
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