You may want to buy stock in an IPO (or initial public offering) to make a quick profit. It can be tempting, given the allure of getting in on the ground floor of a promising company. However, it’s essential to understand the risks and rewards associated with IPO investments before diving in.
High Risk and Limited Availability
Most IPOs carry a high degree of risk. Initially, the amount of stock available for purchase is generally limited. If it is a high-profile IPO, obtaining a substantial amount of shares at the initial offering price can be challenging. Most investors, including institutional investors, end up buying stock in the “aftermarket,” where prices can fluctuate significantly from the initial offering.
Evaluating an IPO
IPOs should be evaluated by comparing the new company’s stock to publicly traded competitors. For example, a food company’s valuation would be compared to other food companies that are already publicly traded. Underwriters determine the attributes of the new company compared to existing competitors, estimate an expected growth rate, discount the risk, and price the stock accordingly. Individual investors should adopt this same approach to make informed decisions.
Management and Underwriters
Consider the background and incentives of the people involved in the IPO. Key questions include:
- Is management selling all their shares or retaining a significant portion?
- Are the underwriters and accountants associated with the prospectus well-established firms or relatively unknown entities?
These factors can provide insight into the stability and potential of the investment.
Assessing the Risk
Deciding to buy an IPO should be based on your willingness to assume the risk that future growth or management plans may not materialize. You must believe the underwriter has potentially undervalued the company’s prospects.
Special Considerations for Different Types of IPOs
Technology Stocks: Technology IPOs often hinge on the future potential of cutting-edge technologies rather than current sales or profits. If you do not thoroughly understand the technology, it may be wise to avoid investing in such stocks due to the high uncertainty involved.
Mutual Savings Banks: These banks are initially owned by their depositors. When they become publicly traded, depositors often have the first opportunity to buy shares. If you are a depositor, carefully review the prospectus provided by the bank to understand your eligibility and the potential investment.
Biotechnology Stocks: These companies often face significant cash flow challenges due to the costs associated with research and development and the lengthy FDA approval process for new drugs. Ensure the company has a major blue-chip investor or substantial financial backing to mitigate these risks.
Strategy: Wait and See
A “wait and see” strategy generally provides the best risk-reward potential for IPOs. Although the excitement of buying in early can drive stock prices up quickly, this speculative approach is often risky. It is usually better to wait four to six months, or even a year, to observe the company’s performance and market behavior. However, if you are confident in the company’s prospects and can hold the stock for the long term, getting in on the ground floor can be rewarding.
Conclusion
IPOs can offer significant opportunities, but they also come with considerable risks. A thorough evaluation of the company’s prospects, management, and underwriters is essential. Adopting a patient and informed investment strategy can help mitigate risks and potentially yield substantial rewards. Always consider consulting with a Fee-Only financial adviser to guide your investment decisions and ensure they align with your overall financial goals.
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