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?