Should you invest in an IPO?
Updated: Feb 12
Author: Marco Murenu
Date of publication: 09/02/2023
Are you thinking of buying stocks at IPO price, but you don’t have a clear idea of what this is and how it works? Then this article is for you.
The IPO: a short introduction
The Initial Public Offering of shares (IPO) is a process through which a private company starts to sell its stocks in the stock-market. In particular, the market where stocks are issued and sold to the buyers for the first time is the primary stock market. So, at the end of the IPO process, a private company becomes public. The main reason a company decides to go public, is to raise money and expand its activity. Indeed, by selling stocks in the stock-market, the company obtains money, which can be used to make investments and grow the company. Therefore, the money obtained through stock-selling is called equity, and investors who purchase shares are the shareholders. Afterwards, shareholders can sell to other investors the stocks they own. In addition, the market where shareholders sell and buy stocks of public companies is called the secondary stock market. However, to make sure that everything is clear, here is an image that summarizes what has been explained so far.
I want you to be aware that a company can also sell stock without being public. In this case the private company offers unregistered stocks to a selected group of investors (generally friends, banks and mutual funds). Not to the public as it happens with the IPO. So, this type of securities offering is called private placement.
If you have read this far, great job! You have figured out what an IPO is. The next step now is to understand what are the phases that make it up.
The phases of the IPO
IPO is a complex process which lasts generally from 6 to 9 months. Specifically, the process can be divided into 4 steps.
Investment Bank Selection
The investment bank is the entity that handles and manages the entire IPO process. For example, it prepares the prospectus which introduces the company to the market. Also, it sets the initial stock price and manages all the legal documentation as well as underwrites the stocks of the company. That means that the investment bank sells the stocks to investors on behalf of the company. Therefore, the selection of the right investment bank is crucial. So, the decision should be based on several aspects, among which:
- The reputation of the bank
- The bank’s network of investors
- The bank’s experience in the company’s industry
- The quality of analysts of the bank
- Support services post-IPO
The second step includes the filing of a registration statement with the Security Exchange Commission (SEC). This document has lots of information, such as operations of the company, finances management, the background of the managers, etc. Thus, the aim of this step is to make sure that the company is ready to become public. If so, the SEC will set the date for the company’s IPO.
This document is filled by the investment bank, and it addresses every potential investor. In particular, it includes information about the company and expected future operations and performances. Hence, the main objective in this step is generating hype and interest in the IPO.
This step starts when the investors send to the company their intent to buy the stocks through the Indications Of Interest (IOI). Once the company knows how many investors want to buy the stocks, it will set the IPO price. Actually, that’s the price that investors need to pay for each stock. After that, the company will communicate the IPO allocation. Indeed, sometimes an IPO can be oversubscribed, meaning that the demand of stocks is higher than the supply. In this case, each investor will obtain just a part of the stocks ordered.
Moreover, at this point each shareholder can sell the shares in the secondary market. The volume of demand and supply will then determine the market price of the shares, which can be higher or lower than the IPO price. If IPO price is higher than market price, the share has underperformed; if IPO price is lower than market price, the share has overperformed.
In a nutshell, we have just analyzed each phase of an IPO. Now you are ready to answer the question: is buying stocks at IPO price better than buying them at market price?
Is buying stocks at IPO price a good strategy for investors?
Generally speaking, it isn’t a good idea to buy stocks at IPO price, because it tends to be higher than the market price. In fact, this condition is due to several factors:
The primary objective of the company is to raise capital. That means that the investment bank will try the best to earn as much money as possible. To do so, it will set a high IPO price.
Also, the company promotes the shares as a politician promotes itself in an election campaign. The result is an inflation of the share, which is then sold to a higher price than its real value.
Moreover, buying at IPO price may be riskier than buying at market price. There is a big information gap between the company and the investors. Indeed, while the managers may know more about the company, the investors have no historical data to analyze.
Despite this, you shouldn’t necessarily avoid buying stocks at IPO price. In fact, many stocks (like Netflix, Google and Snapchat) were brought to a low IPO price and then sold later at a higher market price. Therefore, before buying at IPO price, you should get informed about the company’s operations, its financial statement and especially about the use of the capital collected with the stock exchange listing.