There always seems to be a tremendous amount of buzz surrounding companies that are getting ready to go public. However, the excitement that comes along with the chance to profit significantly is almost always overplayed.
What is an IPO?
An IPO (Initial Public Offering) is when the stock of a private company is sold to the public. In other words, the company becomes available for the public to invest into via the stock market.
Reasons a company goes public is to raise money to grow their business, compensate shareholders, pay off debt, or a variety of other reasons.
Excitement of IPOs
If you would have invested $10,000 into Amazon at its IPO price of $18 per share in May 1997, you would have approximately $19,000,000 today.
If you would have invested $10,000 into Netflix at its IPO price of $15 per share in May 2002, you would have approximately $4,500,000 today.
If you would have invested $10,000 into Apple at its IPO price of $22 per share in December 1980, you would have approximately $11,000,000 today.
It’s easy to see with these 3 examples, why people get so excited about IPOs.
So, why do I say NEVER buy an IPO?
All stocks are initially IPOs.
Obviously all stocks have to start out as an IPO, so if you never bought an IPO stock then you would never own stocks. When I say “NEVER” buy an IPO I’m really referring to two situations. First, is when you have the option to buy shares before the stock technically goes public. And second, is when the stock first goes public.
The Initial Offering
In the first situation, it is very unlikely you will be able to purchase shares at the initial offering. IPO shares are generally only available to high net worth investors before they become available to the general public. Even if you were able to get in on the initial offering, the demand for the shares would likely exceed the supply and you would likely only be allocated a few shares, thereby making it quite difficult to see significant profit.
When Shares are Available to the Public
In the second situation, when shares first go public (after the initial offering), most of the profit has already been made. The ones who initially make money are the company insiders (owners) and the investment banks (the ones who underwrite the IPO). Once the stock goes public, there’s a good chance you won’t initially make money. In fact, the share price often times go down dramatically after the shares go public.
Historical Performance of IPOs
Many well known companies, such as Uber, Snapchat, Pinterest, etc. generated a ton of hype at their IPO only to disappoint investors with poor returns. According to Verdad Capital, the median IPO (out of 3,700 IPOs reviewed since the late 1980s) lost 31% of its value 3 years after its IPO. After 5 years, the loss was even greater at 41%.
Furthermore, in Dimensional Fund Advisors’ (DFA) article IPOs: Profiles are High. What About Returns?, DFA reviewed approximately 6,400 IPOs from 1991 through 2018. Their research concluded that the collective group of IPOs vastly underperformed the broad stock market (Russell 3000) by 2.20% per year.
To put that into context, an investment of $100,000 into IPOs would have been worth $653,000 while the same investment in the broad stock market would have been worth $1,155,000. To make matters worse, the investment in IPOs would have been far more risky! If you are going to take on more risk, you better make sure you will be compensated for it.
Why Many IPOs Fail
The reason that many IPOs fail is because most are small, growth-oriented, low-profitable stocks which historically do very poorly. In fact, if there were one group of stocks to exclude from your portfolio it would be these – IPOs or not!
When to Buy an IPO
Wait to buy an IPO. Let the market determine the stock’s true price (see Markets Are Efficient on my website) as opposed to the price the investment bank initially sets. After the dust settles, determine whether or not this is a stock you would want to hold for the long term. In fact, you may want to wait until after the lock-up period ends (the length of time initial investors are required to hold the stock before selling it – usually at least 180 days). If they sell, then this would likely drive the price down, which is what you would want so that you can buy at a better price.
If I haven’t convinced you and you still wish to buy an IPO, then I would suggest doing so with money you can afford to lose. Don’t use your “serious money” (for most people this is their retirement nest egg). I have no problem with an investor taking this course of action. After all, I understand the thrill of the chase!
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CERTIFIED FINANCIAL PLANNER™