What the Heck is an IPO?
A Sexy Market But Only for Experienced Investors
By Kara Stefan
 Critics
of IPOs say the acronym stands for “It’s probably
overpriced,” and that should tell you a lot right there.
An IPO stock--which all kidding aside stands for “Initial
Public Offering”--represents the first time a company
sells stock to the public.
There are two classes of IPOs: the primary offering--generally
when institutional and wealthy investors grab large chunks
of stock, and a secondary offering, when these same investors
cash in their profits by selling their shares to individual
investors like you and me.
The IPO market is a tough nut to crack, which is probably
a good thing. Most IPO companies are in the early stages of
their business cycle and have a short performance track record.
This makes them a more risky venture than your garden-variety
stock that’s been around for years and therefore has
a record to evaluate.
The IPO Market
In the primary stage, IPO shares are typically offered to
institutional investors and long-time investors of considerable
wealth and experience. Broker/dealers tend to reserve IPO
stocks for their best (i.e., highest revenue generating) account
holders, which can cut out buying opportunities for the average
investor entirely.
However, one way to infiltrate the early IPO market is to
open an account and become an active trader with one of the
major brokerages that tend to align themselves with IPO underwriters
or are underwriters themselves. These include among others,
Morgan Stanley, Salomon Smith Barney, and Merrill Lynch.
Do Your Homework
Occasionally the market will forgive you for acting on a hot
stock tip. IPO offerings are not the time to indulge this
high-risk impulse--you just might lose your shirt.
The best way to research an IPO prospect is to pore over
the company’s prospectus, which can be procured from
the company itself, its investment banks, or you can even
download a copy online from www.FreeEdgar.com.
The following is the type of information you want to check
out in the prospectus to help you determine if the IPO is
a good buy:
- Use of Proceeds: Find out what the company has
planned for the money it hopes to drum up with the IPO sales.
Growth and expansion are good reasons; paying off debt is
not. And “general corporate purposes” is not a
good answer either--look for specific and tangible goals
in the “Use of Proceeds” section of the prospectus.
- Who’s Selling Shares: Another red flag is
when current stockholders--usually employees at the management
level--are selling their stock in the initial offering.
These individuals should have confidence that their stock
will be worth a lot down the road, so if they’re selling
a large amount of their own stock, it’s a warning sign.
You can read about this in the “Principal and Selling
Stockholders” section.
- MDNA: This acronym stands for the “Management
Discussion and Analysis” section of the prospectus,
where you should be on the look out for red flags such as
declining profit margins and/or revenues. The company is
required to disclose these factors and provide satisfactory
explanations.
- Check out “Risk Factors”: This section
of the prospectus will detail information such as how saturated
the market is for this company’s products or services,
and whether or not the company is involved in any patent
disputes, pending litigation, or holds excessive debt.
Second Offering
Once you’ve done your homework, your best bet is to purchase
your IPO shares at the second offering, when the company’s
owners and venture capitalists sell to recoup their investment.
This usually happens about 6 months after the initial offering.
Historically, IPOs tend to underperform the broader market
because their initial price typically declines within the
first 3 or 4 months following the offering date. Once the
initial, sometimes wild overvaluation of a new IPO has settled,
the price stabilizes on a price that is a more accurate reflection
of the company’s true worth. This is the best time to
buy, and you can probably afford more shares since the stock
is no longer exuberantly overpriced.
Another easy way to buy IPO shares is through a growth-oriented
mutual fund that invests in this type of stock offering. But
whether you do the research yourself or entrust the job to
a mutual fund manager, take pains to make sure the necessary
research has been done and done well.
IPOs represent an opportunity either to make a sizeable profit
or lose your entire investment in one fell swoop. Are you
game?
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