You’ve probably heard stories of investors making a ton of money on stocks such as Amazon. If you bought the stock when it was initially available to the public, you could be rich today.
Unfortunately, many people don’t understand how to buy stocks in companies when they first become available.
The process, called an initial public offering (IPO), can be mystifying if you’ve never learned much about them before.
Here’s what you need to know about how to invest in IPOs.
What Is an Initial Public Offering (IPO)
An initial public offering is when a private company issues stock to be publicly traded for the first time.
But what exactly does that mean?
Private to public
Companies begin as private companies. A small group of individuals or investors own all of a particular company’s shares.
Over time, some companies grow.
At some point, a company may decide it wants to raise capital so it can continue to grow. The private investors from a company may want to be able to sell their stake in that company, as well.
Eventually, a private company may decide to hold an initial public offering to sell their company’s stock to the public.
This gives private investors a chance to sell shares of stock and allows the company to raise funds at the same time.
The exact rules governing IPOs are complex.
Certain investors may not be able to sell their shares immediately. There are particular rules for what must happen for an IPO to take place.
To make matters more complicated:
For the companies themselves, public companies must disclose a large amount of financial information to potential investors on a regular basis.
After a company becomes public, its public shareholders hold the company accountable for its financial results each quarter.
For this and other reasons, many companies wait quite a while before they decide to have an IPO.
IPOs don't guarantee returns
If you purchase stock during an IPO and that company becomes extremely successful, you can make a lot of money.
At the same time, other companies that have IPOs end up failing. This can result in a total loss.
Where to Learn More About IPOs
If you want to invest in IPOs, you first need to know where to find out what companies will be holding IPOs in the near future.
Thanks to the power of the internet, finding upcoming IPOs is easier than ever.
Many websites have sections dedicated to tracking upcoming IPOs.
Stock exchanges may list only the upcoming IPOs that will list on their exchanges, but other sites may cover a wider variety of upcoming IPOs.
Some of these websites include:
Once you know what companies will be holding IPOs, you then need to know how to determine whether participating in an IPO will be a good potential investment for you.
The first thing you should do is read the company’s prospectus.
The company prospectus contains key information for prospective stock purchasers.
The document should contain:
- financial information
- future opportunities and risks
- how the company plans to use IPO cash flow
The information is required as part of the process when a company goes public, but you should take it with a grain of salt.
Companies can paint themselves in a favorable light while still following the rules.
In addition to reading the prospectus, you should try to do independent research.
- Try to find information from news stories, analysts and any other reliable source you can find.
- Learn about the company’s business model, how they make money, who their competitors are, their history and their future growth potential.
- Dig through information about the company’s executives, culture, etc.
The part to watch for:
Companies holding an IPO don’t have published public financial statements to show previous performance well into the past.
Instead, you’ll have to deal with a bit of uncertainty that you wouldn’t necessarily have with a company that has been publicly traded for decades.
How to Buy Shares of IPO Stock
Once you’ve identified you want to buy shares of stock of an upcoming IPO, it’s time to figure out if you can make it happen.
Buying shares of an IPO at the offering price can be fairly difficult to near impossible depending on your situation.
Many IPOs set a starting price for the stock at the beginning of an IPO.
Let’s say a company sets their share price at $10 per share. Unfortunately, you may not be able to purchase shares at $10.
Many IPOs have many more people interested in buying shares than there are shares available.
Only available to qualified investors
For this reason, the investment banks that work to put together the IPO usually limit who can buy the initial shares.
For example, TD Ameritrade states that they may act as a member of the selling group of IPOs from time to time. When they do, only qualified accounts get potential access to participate.
They state that to qualify your accounts, each brokerage account must have a value of at least $250,000 or have completed 30 trades in the last three months. There may be other eligibility requirements, such as having a certain net worth, as well.
As you can see, not everyone will have access to shares at the IPO price.
So, what other ways can you gain access to an IPO?
Tracking prices post-IPO
Once the initial shares sell at the IPO price, the shares can then begin trading on the markets.
At this point, the stock price is driven by investors’ desire to own the stock.
If the stock is popular, the price could quickly increase. In some cases, the stock can increase drastically almost immediately.
Without a doubt:
This can be frustrating because you miss out on those initial gains if you don’t qualify to purchase IPO shares.
On the other hand, it is possible for stock prices to drop below their IPO price.
In these cases, buying after the stock hits the market can be a blessing in disguise.
Be Cautious When Investing in IPOs
If you do decide you want to invest in an IPO, you should proceed cautiously.
Lack of information
First, you need to make sure you understand what you’re getting into.
IPOs can be risky for many reasons. This includes the fact that there isn’t full information available about a company’s past financial performance.
While the Securities and Exchange Commission requires certain financial statements to be provided in a prospectus, you don’t get the full picture of a company’s entire history.
Next, you need to understand the price you’re paying for the IPO stock.
Will you be able to get the stock at the initial IPO price or will you be buying it after it starts trading?
Even if you’ve spent hours researching a company, you may not be able to snag the initial IPO price.
If you buy after it starts trading, make sure the price you pay is reasonable and not over inflated due to the hype of an IPO.
If the price gets above what you’re comfortable with before you get a chance to buy, make sure you have the self control to pass on the opportunity.
The reality is:
Just because a stock has an IPO it doesn’t mean the stock or company will be successful over the long term. It only means the stock can be publicly traded.
Make sure you understand the fundamentals of the business, it’s future potential and whether they can turn a profit before you buy. Not all IPO stocks will make you money immediately or even over the long term.
Even if you manage to buy at the IPO price before trading starts, you could lose money that day and in the future.
Historical Examples of Returns From IPOs
The returns from an IPO can range from losing everything to making a very handsome profit. Most fall somewhere in the middle.
The dot-com bubble in the late 1990s and early 2000s is a prime example of some very poor IPO returns. In particular, one IPO shows how fast things can turn south.
Pets.com had its IPO in early 2000. While the stock price popped up on the day it debuted, the company went bankrupt less than a year after going public.
There are plenty of IPO success stories, too. Consider how much money you would have made if you invested in Amazon when they had their IPO.
Amazon went public at an initial share price of just $18. Since it went public, Amazon has had a few stock splits. Buying one share of stock at their IPO in 1997 would turn into 12 shares in 2019.
On September 20th, 2019, Amazon closed at $1,794.16. Multiply that by the number of shares you’d now own, which is 12, and your $18 would have turned into $21,529.92 on September 20th, 2019.
However, the bigger IPO picture is somewhere in the middle.
For more details above historical IPO returns, you can check out this detailed report from Jay R. Ritter from the University of Florida.
You Decide Whether IPOs Are Worth It to You
The logistics of how to invest in IPOs are fairly straightforward.
- If you can get access, you might be able to scoop up a company’s IPO stock at the IPO price.
- If not, you’ll have to buy it on the stock market on the first day of trading.
Buying the stock may or may not be a good move. It’s a complicated decision.
You may want to consult with your financial advisor for more guidance. They can help you determine whether investing in IPOs is a good choice based on your financial plan and investment goals.