Purchasing any type of stock can be a little stressful, especially for beginners. Investing in IPO stocks takes that stress to a whole new level. IPO stocks, or initial public offerings, are extremely volatile and difficult to predict and navigate. For this reason, it’s very important that investors looking to purchase an IPO stock understand the entire process.
The following is a summary of how to buy IPO stock:
- Work With an Online Brokerage
- Do Your Research
- Read the Prospectus
- Know the Risk and Warning Signs
- Be Okay With Waiting It Out
- Consider Investment Banking or a Mutual Fund
What Is IPO Stock?
An IPO, or initial public offering, occurs when a private company goes public through the offering of stocks on a securities exchange market like NASDAQ or the New York Stock Exchange. A few reasons a private company might choose to go public include the following:
- To maximize shareholder value
- To offer investors and employees liquidity
- To reinvest in and grow the business by raising capital
- To develop mergers and acquisitions using stock
Once the bank designates the initial price to the stock, it’s placed on the open market where supply and demand will then dictate its price. At this point, individual and professional investors are able to purchase this IPO stock and begin trading.
Work with An Online Brokerage
Many of the bigger online brokerage firms have established contracts with various investment bankers to receive IPO stock. For example, the online brokerage, Fidelity, has contracts with Kohlberg Kravis Roberts and Deutsche Bank to acquire shares of certain IPOs at their initial offering price.
When choosing an online brokerage, you want to look for a company with a reputable underwriter. Occasionally, larger investment banks will have a failed IPO; however, most of the time you can count on a strong brokerage to bring on strong companies and IPOs. Smaller brokerages are typically more desperate, so they tend to be more willing to underwrite any company that comes their way. Essentially, the bigger brokerage firms have the ability to pick and choose while the smaller brokerage firms do not.
One advantage of a smaller brokerage is that individual investors can more easily purchase pre-IPO stocks. With larger brokerage firms, investors typically have to be a long-term, established customer with a large net-worth before they can purchase an IPO.
If you already have an online brokerage and are looking for a specific IPO, you can check with your brokerage to see if it offers the IPOs you want.
Do Your Research
Acquiring information on a private company that is set to go public is no easy task. A private company is typically not at the top of analysts’ lists when it comes to digging up hidden information. While most companies usually provide a prospectus containing fully disclosed information, it’s important to keep in mind that this prospectus is written by the company so it will likely be biased.
You can acquire your own information by searching the internet for any data you can find on the private company and its competitors. Although reliable information might be hard to find, you can usually dig up some financial information, past press releases, and the overall health of its industry. Doing adequate research of your own will help you decide whether the company would be a smart investment or not. After doing your own digging, you may find that the prospectus is inaccurately optimistic and you’d be better off staying away from its IPO.
Read the Prospectus
While the prospectus should not be blindly trusted, it is still offers important information concerning the company’s risks and opportunities. It also features its proposed application of the money that the IPO brings in.
You can get a feel for the company’s financial situation by reading between the lines. For example, if the prospectus states that the money from the IPO is allocated toward loans or equity, that’s a bad sign. A company that can’t afford to pay its loans without additional income is not a good company to invest in. On the other hand, if the company states that the IPO funds will be put toward expansion, research, or marketing, you can more confidently place your faith in their financial situation.
Another thing to look out for while reading the prospectus is an exceptionally optimistic future earnings outlook. This is a sign that the company is likely over-promising and will therefore, under-deliver.
If you can’t locate a company’s prospectus, you can request it from the broker that’s bringing it public.
Know the Risks and Warning Signs
When it comes to IPOs, it’s a good thing to be a skeptic. With IPOs comes a lot of uncertainty, therefore, investors should always proceed with caution. If your broker outright recommends an IPO, it’s likely that he’s looking to find a buyer because others have been turning it down or aren’t interested. Essentially, the broker is offering you the leftovers that the professional investors didn’t want. This is a situation that should be handled with caution.
IPOs are an attractive investment because they offer an opportunity to earn a large profit quickly; however, a stock that has a potential of big earnings also has a potential of big losses. For example, Pets.com was a promising IPO that liquidated less than a year after going public. Another company, Groupon, has yet to meet the level of returns that it had promised at its offering.
An analysis conducted on companies that offered IPOs between 1975 and 2011 shows that of over 7,000 companies that went public, 60% of them had negative returns after being on the market for five years. This paints a pretty accurate picture of the risks that are involved with purchasing an IPO stock.
A few steps you can take to minimize the risks of purchasing IPOs include the following:
- Do your research
- Start small and don’t purchase a large amount of volatile stock all at once
- Keep your portfolio balanced
Remember, there’s nothing wrong with investing in IPO stocks. You just need to know what you’re getting into and proceed with caution.
Be Okay With Waiting It Out
When an IPO is released to the market, it experiences a lock-up period that legally binds the underwriters and company insiders to the stock for 3 to 24 months. This means that until the lock-period ends, they cannot sell their shares of the stock.
Investors can use this lock-up period to their advantage by waiting for the period to expire. If the insiders immediately start selling their shares as soon as the period ends, then it’s a sign that they don’t feel the stock is a good investment. If they hold on to them, then you can somewhat confidently assume that the company truly perceives an optimistic future.
There’s nothing wrong with letting the market do its thing before you invest. If a stock is a good investment, it will stay on the market for many years to come.
Consider Investment Banking or a Mutual Fund
As mentioned, it can be difficult for individual investors to get in on purchasing IPOs at their initial offering price. Typically, when a company goes public, it hires an investment banker to figure out the details and list the stock. If an IPO has a high demand, the investment bankers will most likely offer most of its shares to its own clients.
If you plan on purchasing IPOs regularly, it might be worthwhile to open a brokerage account with an investment banker that regularly offers the types of IPOs you’re interested in buying. If you find that the IPOs you have your eye on keep going to mutual funds, then you could look into investing in the mutual funds that are getting those IPOs.
Investing in IPO Stocks
Investing in companies that have been on the public market for a long time offers a greater amount of security. For this reason, many investors choose to allocate most of their portfolio to these long-standing stocks. However, IPOs can also be a profitable and exciting investment opportunity. If you do your research and keep your guard up, you just might find yourself as a shareholder in a highly profitable company.
Are you trying to figure out how to buy IPO stock? Check out the team at Raging Bull. They offer a host of free resources like their free starter pack. The expert investors at Raging Bull are more than qualified to help you navigate the risky game of investing in IPOs so that you can hit the ground running.