An initial public offering, or IPO, is the first sale of stock by a company to the public. A company can raise money by issuing either debt or equity. If the company has never issued equity to the public, it’s known as an IPO.
Many retail investors think they can make a fortune by buying a stock in the IPO process. It is a stock market myths that I would like to debunk today.
Are you sure you can value an IPO?
First of all, the company who is issuing IPO has no public track record. Whatever written in the prospectus (if you ever read) will not help you much as the document is drafted for the purpose of promoting the company.
It’s already hard enough to analyze the stock of an established company. An IPO company is even trickier to analyze since there won’t be a lot of historical information.
LinkedIn’s banker Goldman Sachs was paid $39 million yet they still mispriced the IPO by 100%.
IPO is just selling stock
Investors must understand the primary goal of an IPO is to sell the pre-determined number of shares being issued to the public at the best possible price.
Usually, IPO is used by the small business go to the public to raise cash to expand their business. As a result, many times, the IPO becomes the end rather than the beginning as the objective is fulfilled.
IPO is all about the sales job. If you can convince people to buy stock in your company, you can raise a lot of money.
If you do get shares, it’s probably because nobody else wants them. The hot IPOs are usually snapped up by the big institutional investors or the very best wealthy clients of the underwriting firm.
Yes, there are exceptions to this rule, just keep in mind that the probability isn’t high if you are a small investor.
Why are investors so interested in IPOs?
It is important to understand that underwriters are salesmen. The whole underwriting process is intentionally hyped up to get as much attention as possible.
If your stockbroker calls you today to talk about Singtel stock, you may immediately hang up on him. But if he tells you that there is this amazing company who has bright future and now is offering a “once in a lifetime opportunity” to buy its IPO, you probably want to check it out. After all, people like scarce things, even if it is a piece of junk.
Then you try to search the web, read the newspaper, ask your friends. Everything you hear about this company is, of course, fantastic. After all, this is what is designed to be.
“I will sell the IPO on the first day it debuts”
So do I! So does everybody!
Investors always misunderstand the real liquidity of the stock market. They often forget if you want to sell your stock, someone has to buy it. If everybody wants to sell the IPO after it launches, the price can only go down. If you want to offload your shares, you have to find a greater fool who is willing to pay more than what you have paid.
“I will hold the IPO until the price rises”
This is what I call Karung Guni Investors. These investors buy all kinds of stocks whenever they are offered at “seemingly cheap price” and hope to sell it to somebody else in a future day.
You can definitely make some money in this way as you should always be able to find some people who value the antique chair more than you do, but you will surely turn your home into a junkyard in the long run.
“Some IPOs soar high and keep soaring!”
Yes, granted! LinkedIn nearly doubles the IPO price. But back to my second point, how much IPO shares do you think you, as a retail investor, will be allocated in the first place. The share soared simply because many desperate investors were not allocated the shares during the IPO process.
After all, many IPOs fall all the way since their debut.
“So I should not buy IPOs at all?”
As Warren Buffett once commented IPOs,
It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors).
Buying IPO is just like buying any other stocks. The questions that you ask yourself should be the same as if you are buying any other stocks.
- What is your risk tolerance level?
- How does this investment fit into your portfolio
- Is the IPO fairly valued, discounted or at a premium?
- What price should you sell for a profit?
- What price should you cut loss no matter what?
If you haven’t thought about these, I suggest you not to hit the buy button now.