5 Questions to Ask Before Investing in an IPO

When a privately held company decides to go public, it usually does so through an initial public offering, or IPO. Established consumer brands often get a lot of media attention when they decide on an IPO. While brand recognition can be appealing to investors, knowing a brand is very different than investing in a brand. Here are some things to think about, starting with a few IPO basics.

IPO 101

First off, some lingo to know. The company offering the stock is the "issuer," and the IPO process is usually led by a group of investment banks referred to as a "syndicate." The investment banks are the underwriters, and are responsible for handling details such as meeting regulatory requirements and filing deadlines, as well as helping to determine pricing for the IPO price. The investment banks also work hard to create demand for the stock and secure purchase agreements from large institutional investors.

Primary vs. Secondary Markets

Institutional investors typically buy stocks directly from the company. This is called the primary market, and most early trading activity during an IPO is done in this way. However, shares can be allocated to retail investors associated with the investment banks, but typically this is somewhat limited. It's the secondary market — when shares start trading on an exchange — that allows for wider accessibility for a broader range of investors. 

With the basics covered, here are five key questions to ask yourself about a company that's on your IPO radar.

1. If this weren't an IPO, would I still be interested?

This is a first-round gut check. It's a good idea to figure out if your interest is rooted in portfolio strategy or if you're captivated by the hype, the media coverage or the "Oh, I love that brand!" feeling that modern-day IPOs create.

Consider doing a simple, broad-strokes review of your overall investment plan, your portfolio, the company and the sector. Is it a reasonable addition to your portfolio mix? Or does it stray too far from your chosen path?

2. Do I understand the risks involved?

Participating in an IPO means adding shares of a new stock to your portfolio. This comes with the same risks associated with owning any stock — market, macroeconomic and individual company risks. In addition, the IPO process itself has a unique set of risks to consider.

Price volatility is a top consideration. When it comes to IPOs, the price can, and often does, fluctuate dramatically once trading begins in the secondary market. For example, when the Coca-Cola Company went public in 1919, shares hit the market at US$40 per share. The price reportedly dropped to US$19 per share during the first year of trading.The Coca-Cola story in the end, of course, is considered a huge success for investors who got in on the IPO, but only after that significant drop in the months following going public. (Fun fact: The stock has split 11 times, so one share purchased at the time of the IPO would give a shareholder 9,216 shares today!)

The lesson from Coca-Cola remains relevant today: we can't predict an IPO's price pattern, and because there's no historical pricing data to go by, price volatility tends to be even higher.

Early price volatility can be driven higher by media coverage as well as investors who buy shares only to sell (or "flip") the stock immediately in an attempt to turn a quick profit. A later price drop can also occur, months after the IPO. Company insiders are typically subject to a "lockup period" after an IPO, which prohibits them from selling their shares in the early days. The end of a lockup can cause a price drop, as many shares will suddenly become available on the open market.

3. Why is the company going public?

Companies go public for different reasons, and understanding the motivation behind an IPO provides a window into the company's thinking. Here are some common reasons why a company might decide to go public:

• Raising money to grow the business (capital spending, hiring, acquisitions)
• Increasing brand recognition (IPOs draw attention)
• Attracting talent (stock can be a valuable tool to interest top employee prospects)
• Becoming more attractive to companies looking for acquisition targets
• Creating an exit plan for company founders (publicly selling ownership in the company)

This information can help inform your decision-making process.

4. How well do I understand the company?

You want to have a solid understanding of any new investment before adding it to your portfolio. IPOs are no different.

Let's say a well-known consumer technology brand is planning an IPO. They produce tech that you use daily. You might feel comfortable with the brand because you're familiar with the product, but a successful product doesn't necessarily equal a successful company. To get a handle on the business, you'll want to do your research to learn more about the following:

• What does the company do? What products/services does it offer?
• Who are its competitors? How do they compare? Who is the market leader?
• Are the company's financials strong?
• Does it have a competitive advantage? Is it sustainable over the long term?
• Who's on the management team? Are they founders, with an emotional attachment to the future of the company ? What is their track record?
• Does the company have a positive employee culture? Is there high turnover?
• Does the company have clearly articulated plans for how it will use the money raised by the IPO? Are the plans specific and focused on long-term growth?

5. Does this stock fit into my long-term investment plan?

This question is perhaps the most important of all. IPO hype can sometimes be a distraction. Your investment decisions should be driven by your overall financial plan. If the new stock doesn't fit into your strategy, then all the hype in the world shouldn't matter.

By the Numbers: IPO Names You'll Know

Source: Nasdaq