A private firm "goes public" through a process known as an initial public offering (IPO), in which the company makes its stock available for purchase by investors on a stock exchange or an over-the-counter market. IPO stock is an investment that has the potential to be profitable, but there is also a risk that investors would suffer significant financial losses. Find out the pros and cons of investing in initial public offering (IPO) stock, as well as how to evaluate your current investment.
What Does It Mean to Make Your First Public Offering (IPO)?
When a previously private corporation decides to sell its shares of stock to members of the public, this action is referred to as an "initial public offering." In order to get ready for an initial public offering, the company is going to register with the United States. Securities & Exchange Commission (SEC) file significant paperwork and often lists on a major exchange such as the New York Stock Exchange or Nasdaq. The SEC is responsible for enforcing these requirements. Individual investors have the opportunity to participate in an initial public offering (IPO) by purchasing shares of the company as soon as they are made accessible on the public market.The Advantages of Investing in an Initial Public Offering
Investing in a company at its initial public offering might be very attractive. A share of common stock that was purchased during the company's initial public offering has the potential to yield enormous capital gains over the course of several decades. Even merely the annual dividend income of a very successful firm can, over a few decades, be sufficient to surpass the amount that was initially invested in the company. Your investment injects resources into the economy, which in turn makes it possible for businesses that offer tangible products and services to develop and flourish. When the market conditions are favorable, having the knowledge of how to buy IPO stock can lead to highly appealing returns. Think about how much a share of Coca-Cola would be worth if you bought it just after the firm went public. In 1919, the price of a share of the company's stock was initially set at $40 as part of its initial public offering. After more than a century (and many stock splits), an investor who purchased one share in 1919 would now hold 9,216 shares. If those shares were valued at $49 each, which was the 52-week average closing price for Coca-Cola stock as of May 7, 2021, the initial investment would have grown to be worth $452,313—not including dividends. This is assuming that the dividends were reinvested.The Drawbacks Associated with Investing in IPOs
Dealing with unpredictable price swings is the most significant drawback for investors in an initial public offering (IPO). When the value of your shares falls, it may be difficult to maintain your investment in the company. When stock prices fall, it's difficult for many investors to maintain their composure. They look to the market for information rather than assessing the company themselves and buying in accordance with that valuation. Nevertheless, in doing so, they fail to grasp the distinction between something's intrinsic value and its market price. Instead, you should think about whether the look-through earnings and dividend growth are expanding and are likely to continue growing in the future. Not every initial public offering has a successful outcome. Take, for example, Webvan, a grocery delivery service that operated throughout the dot-com era. After only three years in operation following its first public offering in 1999, Webvan incurred losses amounting to hundreds of millions of dollars. Those investors who bought in for $26 per share on the initial public offering (and witnessed growth of 58 percent on the first day) and continued to hold would eventually see their shares collapse to barely 6 cents apiece as the company filed for bankruptcy in 2001.The IPO Market from the Perspective of Traditional Value Investing
Benjamin Graham, known as the "Father of Value Investing," wrote in his book "The Intelligent Investor" that anyone interested in investing should avoid participating in any initial public offerings. What is the cause? During an initial public offering (IPO), the company's former owners will try to raise capital at a higher price than usual. As a result, there is a slim chance that you will be able to purchase your stake at a lower price. Instead, he recommended that they wait for some setback in the firm, which will cause the stock price to plummet after a few years and provide an opportunity to load up on shares at a discount. The perspective that Graham advocates for is one of conservatism, discipline, and safety. It reduces the likelihood of getting burnt, and the typical investor will likely do well in the long run if they adhere to that approach.How to Determine If Buying an IPO Stock Is Right for You
If you've settled on investing in an initial public offering (IPO), one important consideration to keep in mind is the merits of the underlying company. Put the following crucial questions to yourself:- What is the most plausible explanation for why this company is not expanding at a rate that is high enough to warrant the price it currently commands?
- When it comes to certain failures, what are the odds that they will occur?
- How does the company protect itself from the threat posed by competitors?
- Are there any intellectual property protections in place, such as patents, trademarks, important personnel, or anything else that sets it apart?
- What prevents another company from entering the market and ruining the lucrative economics that has been established?
The Crux of the Matter
When it comes to making a profitable investment in an initial public offering (IPO), the odds are stacked against you. Initial public offerings, as a whole, do not fare very well in comparison to the market. They frequently already have an ideal price tag attached to them. Find out exactly what it is you want to get out of your investment before you make it. Think about the fact that you might have to be patient and wait, maybe even for years, for the ideal chance to present itself at the right time. This opportunity may arise during an initial public offering (IPO), but more often than not, it will call for discipline, impeccable timing, and extensive research.Questions That Are Typically Asked (FAQs)
How do I buy pre-IPO stock?
A pre-IPO placement refers to when a firm sells a certain number of its shares to private investors at a discounted price before the company goes public. Because these are privately traded shares, they are not subject to the regulations of the SEC. Due to the fact that they can be purchased by only qualified investors, a large number of individual investors are unable to get their hands on them. If you are asked to buy pre-IPO shares, you should exercise caution because there is always the chance of being taken advantage of, and you should also conduct research.How is the price of an IPO established?
The process of calculating the price of an initial public offering is a complicated one. It is determined by the lead investment bank that is underwriting the initial public offering (IPO), and it is based on the financial status of the firm, the valuations of comparable companies, and the sales abilities of those who are setting the price.