Every day, it seems, millionaires are created out of thin air as investors turn a few bucks into vast fortunes just by picking the right IPO.
But in reality, it's not that easy.
Despite the highly successful offerings the market has witnessed recently, investing in an IPO can be a risky venture for investors who don't do their homework. Fortunately, that risk can be reduced with education.
Knowing how an initial public offering is priced, what actually happens on the first day of trading the new issue, and how to manage expectations is critical information you should be aware of before calling your broker and jumping in with both feet.
Two IPO myths
Before getting into the finer details of the IPO process, I first want to dispel two myths:
Myth #1: Companies open their doors one day, and then go public the next.
A new public issue is actually the culmination of years of hard work, market positioning, rounds of financing and business success - rather like sending a child to college. The parents' job is to prepare Junior well enough to be successful on his or her own; offering a company to the public is no different. And, as with parenting, you can never be too sure what will happen once the baby leaves the nest.
Myth #2: Companies expect to make a vast amount of money from going public.
Traditionally, the IPO is simply a vehicle for getting a company into the market; the real money comes from a secondary offering of shares. Here's an example of how IPO logic works. Say "Justin's House of Elvis," a retailing concern, goes public with an offer of 6 million shares at $14 per share. The company trusts that the underwriters have done a good job of getting the stock into the right hands and have explained exactly how the company makes its money, how it plans to grow, and how it stacks up against the competition. Assume that Justin's House of Elvis continues along the path it laid out to investors and demonstrates good returns on the open market, and six months to a year later it does a secondary offering of 3 million shares at $42 per share. Less stock sold at a higher secondary offering price equals greater profits for the company, and less dilution on the books (less effect on earnings per share).
Choosing a date for the IPO dance
The IPO process is not an exact science. There is no set of instructions that will guarantee a successful offering. That elusive animal - market sentiment - can determine whether an offering becomes a highly successful public company or never gets off the boardroom table. However, there are several steps the company and the underwriter take to give the company the best possible chance at a successful offering.
A crucial decision facing a public company wanna-be is the choice of a lead underwriter. Wave after wave of investment banks offer their reputations, performance, analysts and trading prowess in order to win this spot in the IPO process. The choice must be made wisely as potential IPOs are in part evaluated based on their underwriters. A big bank with a reputation for seeing its clients through a succession of follow-on offerings will immediately add legitimacy to a company seeking to go public.
However, hiring a big bank might not always be in the company's best interest; it may prefer a smaller underwriter to lead the offering, as smaller banks tend to give the process a more personal feel. The choice really depends on how the client likes to do business.
Once the underwriter is chosen, and the requisite paperwork is filed with the SEC, the company goes on the road to tell its investment story. It is at this point that management and the lead underwriter have the most contact, as it's the bank's responsibility to put the client in front of the highest quality institutions, and it's the company's job to sell its business.
As the road show wears on, the underwriter gives its client feedback on meetings, updates on the "size of the book" (the amount of shares institutions have indicated they would like to purchase) and most importantly, directions on what the company should do if the reception is less than warm. As indications of interest begin flowing in, the haze surrounding the question of price begins to clear.
Pricing Justin's House of Elvis
Historically, IPOs have been priced to institutional demand. The underwriter will set an initial price range (e.g., $12 to $14) based on, among other things, a discount to the current trading range of the company's publicly traded competitors. The institutions, having done some tire kicking of their own, inform the underwriter how much stock they would like to purchase (e.g. 100,000 shares at $14) and whether they will continue buying stock in the aftermarket, the actual stock market itself, and at what price (e.g. up to $30).
Let's look at how the price would be set for Justin's House of Elvis. First, every indication of interest would be charted and weighed (based on the quality and reliability of the company) until it became clear just how desirable the offering was.
Let's say Justin's House of Elvis is offering 6 million shares and institutions have indicated a demand for 60 million shares ("10 times oversubscribed," in banker-speak). Based on this, the lead underwriter knows that it has enough demand to allocate the vast majority of the stock to the highest quality institutions.
Thus, that order for 100,000 shares is likely to end up at around 25,000 to 40,000 for a reliable, well-known investor and around 1,000 to 5,000 for a smaller firm. By not filling the entire order, the underwriter is creating demand for the stock once it is on the open market. Should the offering be less well received, with only 30 million shares of interest, the larger, more reliable institutions will get an increased percentage of the initial indication as the underwriter can be relatively certain they will hold the stock and support it.
If the offering is a go, the underwriter buys all the shares from the company, sells them at the agreed price to the institutions and co-managers of the deal, and the table is set for Justin's House of Elvis to begin trading the next day.
Green shoe or runaway IPO?
Underwriters have a good idea of where the institutional demand will take the stock in the first day of trading. Part of the research process is to find out which of the institutions will "flip" the stock (sell it on any price increase for a quick profit), which institutions will hold it, and which will continue to buy into the aftermarket (and how much). Because the underwriter can make sure that the institutions follow through on their intentions (and block them out of future deals if they don't), it can be fairly sure of who will do what, and when. The underwriter prices the stock in anticipation of a modest first-day gain, say 20%, counting on the institutions and the general public to bid the stock higher.
However, should the stock falter, the "green shoe" provision can be activated. This is a safety feature that enables the underwriter to sell more stock than it purchased so it can buy back stock, which supports the stock price.
You may be asking yourself, if it's that uncertain, why are all these IPOs going through the roof? While there is no one simple answer, I do believe the increased public consumption of IPOs through online brokerages is a big factor. Because the underwriter doesn't allow the stock to begin trading until the day's session is a few hours old, institutions and the public have plenty of time to enter bids. The hotter the deal, the more people want in. The more people want in, the higher the asking price.
As the supply of stock available or "float" is generally very limited (an average of only one-sixth of a company's total equity was offered via IPOs in 1999), bids can start coming in at 5 to 10 times the original price by the time the stock finally opens. If this happens and the public jumps in, while day traders buy and sell with ridiculous speed, the stock price may soar into the stratosphere.
Past IPO performance cannot guarantee…
However, this doesn't happen on every offering nor is a huge one-day return a guarantee of future success. Also, as the average IPO returns for 1997 through 1999 show, last year was a banner year and should not be considered the norm. The average IPO returned 173.6% (through Dec. 31, 1999) compared with 20.0% and 24.3% for 1998 and 1997.
Even more telling, the median returns for the same time periods were 90.9% (1999), -1.5% (1998), and 11.5% (1997). This means that in 1999 more than half of IPOs had returns of 90.9% or better, but for 1998 over half of IPOs had negative returns (even though the average return for that year was 20%). These factors alone give reason for pause and remind us that there are no sure things.
As an investor, you should buy into an IPO for the same reasons you would buy stock in an established company - because you believe in the company, its business and its prospects for success. If you go in thinking that a huge cash windfall is just around the corner, odds are you will be sorely disappointed.
Investing in an IPO can be a very rewarding experience, financially and intellectually, and provided you continue to take a long-term view, can be worth the risk. But you should always remember that buying an IPO with the expectation of a huge, short-term return is a recipe for disaster.
Besides, if all you're really looking for is a little instant gratification, why don't you come on down to Justin's House of Elvis? I've got a great velvet portrait of the King with your name on it.