Q: I have heard stories from friends who made a lot of money from investing in IPO (initial public offering) stocks. There are several IPOs that are upcoming in the next few weeks and I am thinking if I should invest this time around? Is it good to buy? - Raiza, by email
When a company goes public, they sell a portion of their ownership to the market known as Initial Public Offering or IPO. An IPO allows a company to raise capital for expansion from the public while investors make money from the IPO by trading the shares at the stock market.
Investing in IPOs can be lucrative because there are IPO stocks that easily double or triple within a few months. DoubleDragon and Xurpas have been big IPO winners in the past but not all IPO are always successful.
Investing in IPOs can also be risky. Because of lack of historical reference in share price behavior, an IPO stock can be unpredictable in many ways especially in the first few weeks of trading.
Making money from IPO requires some skill and tolerance for risk that may be different from investing in established companies in the stock market.
How do you know if you are investing in the right IPO? How do you manage your risk and profit from it? Here are the five tips everyone should know before buying IPO stocks:
1. Know the company behind the IPO
Investing in an IPO is like buying regular stock that needs careful research. You don’t buy an IPO because your broker asked you to or you see everyone buying it. Sometimes the underwriters responsible for the IPO hype up the stock too much that you feel you are missing an opportunity of a lifetime. Take time to research by reading the information provided in the IPO’s prospectus.
The key to profitable IPO investing is to know the company behind the stock. Can you comfortably explain the business model of the company? How attractive is the industry where the company belongs?
You can also check the financial track record of the company. How reliable is the earnings power of the firm based on its financial history? How stable is its financial position? How trustworthy are the controlling shareholders? How capable are the members of the management team?
2. Know how the company intends to use the IPO proceeds
When you read the IPO prospectus, make sure to find out how the company plans to use the proceeds from the public. For example, there are companies that will use a portion of the IPO money to pay off existing loans, which may not add so much value to the future income of the company.
As an investor, you want to see the company use your money for future expansion, not for loans that have been incurred in the past. While it is normal to use a portion of the IPO proceeds to pay off loans, the larger the allocation for debt repayment, the more unfavorable the offer becomes.
Another example is when some shareholders sell a portion of their existing shareholdings known as secondary shares to the public as part of the IPO. When secondary shares are sold, the proceeds do not go to the company for expansion but for the enrichment of the owners, who cash in on their shares.
3. Know the share price offering and its valuation
Buying an IPO at offer price does not mean you are buying it at the lowest price. It simply means that the IPO offer price is the price that the owners of the company are willing to sell to the public.
If the IPO price is deemed expensive, the stock will likely fall when it gets listed in the market because investors will immediately cash in on the shares. If the IPO price is considered cheap, investors will likely buy more shares when it gets listed, pushing the stock price to go up.
One way to know if an IPO is expensive or not is by getting the P/E ratio of the stock based on its projected income. The P/E ratio is computed by dividing the IPO offer price with the expected earnings per share.
If the P/E of the IPO is lower than the market average, let’s say the P/E offer of the stock is 10x and the market average is 20x, the stock can be considered relatively undervalued that promises upside potential. The bigger the discount to market valuation, the more attractive the IPO.
4. Know how much shares of the company are going to be offered to the public
How much of the company’s outstanding shares shall be available for the public to trade? It is important to consider the liquidity of the IPO because this affects how the share price will behave in the future.
If the free float is small, say at a minimum of 10 percent, you can expect the stock to be more volatile because there are only a limited number of shares available. Higher volatility means higher risk because the share price can swing at a large percentage within a few days if it is actively traded.
If you are investing for the short-term, this can be a good opportunity for you. But if you are investing long-term, prefer an IPO with bigger free float, say 25 percent or more, so that there is higher stability in the share price movement. Institutional investors, such as foreign funds, prefer larger free floats so they can trade with a significant number of shares without necessarily affecting the share price.
5. Know your investment strategy
Many people buy IPO shares with the intention of unloading it immediately for quick profit. Some buy it for long-term. When you invest in an IPO, it is important for you to define your investment strategy.
IPOs can be volatile in the first few weeks of listing. It can shoot up high quickly or fall immediately. You need to manage your risk by setting a target price to sell. If your stock falls badly, you also need to set a price to cut your losses.
Ideally, you need to sell your IPO at a good price when you have the opportunity to do so because it may not stay that way for long. When the company fails to deliver its promises after one year, the stock price may fall.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice email@example.com or follow him on Twitter @henryong888