How to Evaluate an IPO

evaluating an ipo

An IPO launch can be an exciting opportunity for investors who want to get in on the ground floor of a newly-made public company. Companies decide to go public in order to accumulate a massive influx of cash, which is then used for product development, capital investments and other things that help it grow larger.

Before the launch, though, there is relatively little information made available to investors about the company. They might have a good idea of what the business is and what the company direction will be, but most of the information comes from media coverage. Because it’s brand new, there isn’t a track record to analyze or ratios to compare. Even details like financial statements aren’t readily available, making the initial price difficult to judge as to whether or not its fairly valued or overpriced.

From IPO to your portfolio

Most investors have little knowledge as to how an IPO is actually priced. In practice, the initial pricing generally follows the basic rules of supply and demand. If demand is high for a particular IPO, the price goes up, since the number of shares being issued stays the same. Some industries, like technology tend to garner higher premiums for IPOs due to the interest of investors, while other times demand changes depending on what industry is popular at the time.

Multiples for the IPO pricing are based off competitors helping investors pinpoint whether a stock is overpriced or not. For example, if investors are willing to pay 20 times earnings for a software developer, then an IPO price will be set with this as a guideline.

But more often than not, IPOs are mostly priced based on their marketability rather than fundamental numbers. The idea of what the company is capable of doing or might do can overpower the reality of its current financial situation simply because it is new.

Sometimes though, investors won’ have much to go on other than market opinion. When Google first went public, the IPO price quickly jumped to levels that some analysts felt were unsustainable. But the stock price kept steadily climbing until it became a tech staple of almost any portfolio. Twitter, on the other hand, debuted at $40 per share and quickly rose to nearly $70 before correcting downward, eventually settling at the $15 range.

 

Investing in an IPO is risky considering the lack of information available. Many times, prices get hyper-inflated on pure speculation, only to fall by 50 percent or more less than a month later. Due diligence is doubly important in these kinds of offerings, but even this isn’t always a good predictor of future movement. Unless you’re willing and able to take the risk, it’s usually best to wait a while before jumping into a newly issued stock to see how it settles after the initial hype is over.