We continue our three-part series on understanding IPOs with Part II, where we share considerations investors may want to consider when contemplating participation in an Initial Public Offering (IPO). Below, we highlight four areas of attention prospective IPO investors should give thought to.
Good stock vs. Good Company
When a unique or attractive business decides to go public, it's natural to get excited about the opportunity to own and participate in a business viewed as a great company. However, investors must recognize there is a difference between a good stock and a good company. Considerations that go into the difference between the two include:
Valuation – the valuation of a company embeds expectations around future growth. An investor’s analysis should infer the expectations for revenue and earnings growth incorporated into the IPO valuation and whether their view of the growth potential exceeds those expectations.
Management – at times, newly public companies are led by founders or management teams that were in place early in the company’s formation. Those management teams may still be the right individuals to lead the business, although in some instances, as companies mature a different skillset may be required to execute on the next leg of growth. Investors should assess whether the skills that enable the company to grow to this point remain the ones needed to lead the business as it continues to mature.
Governance – Board composition and shareholder rights need to be considered. Is the board composed of friends and those loyal to the management team that won’t challenge strategic decisions? Do corporate bylaws provide certain share classes with more rights? As an investor, are you comfortable with this?
Growth Trajectory and Visibility
Maintaining an elevated growth rate is far from easy. As successful companies grow, the additional revenue or profitability needed to sustain an elevated rate of growth continues to increase. When assessing a company’s ability to continue its growth, one should understand the size of the market(s) a company is participating in as well as how the company’s market share could shift as competitive dynamics evolve.
A straightforward question we often ask ourselves in evaluating an investment is what do we need to believe in order for the investment to be successful. When assessing the growth trajectory and triangulating it with our earlier point on whether this is a good stock based on valuation, one should ponder what expectations support the current valuation and what would need to transpire for this to be a successful investment.
Second, newly public companies are often still early in their corporate life cycle. They may still be investing in their business and have opportunities to expand profit margins over time as their growth continues. Further, going public may also be a solution for raising additional capital to support business growth initiatives. These are just a few questions that investors should reflect on to gauge whether they have sufficient visibility into the business's financial profile.
Elevated Volatility
New IPOs are often volatile in the first days/weeks of trading. A key influence on this is the market sorting out the balance between investor demand for that stock and the amount of shares available. For stocks with insufficient supply, the price will rise until investor demand diminishes. Alternatively, if the IPO is too large and there isn’t enough demand, the price will fall until it reaches a level that incentivizes greater demand.
This volatility has more to do with technicals, or investor sentiment, and may not be a function of the business's quality or growth trajectory. IPO investors must recognize that volatility may be elevated and that near-term performance will not be entirely driven by the business's fundamentals. As such, technical swings can lead to elevated daily price movements in the early stages of trading.
Importance of Buying Now or Later
There is no doubt an element of excitement that comes with participating in an IPO. As we discussed in our prior piece, The ABC’s of IPO’s, new stock offerings are more volatile, especially in the early days of trading. What some investors may not appreciate is that receiving an IPO allocation often comes with broker guidelines that discourage selling IPO shares in the first day(s) of trading.
Further, companies often issue a minority percentage of shares at the initial IPO, with follow-on offerings distributing a larger piece of the company. As expectations for follow-on offerings approach, the price of shares may drop as investors await an opportunity to purchase shares, ideally at a discount, from additional share issuance.
We point out these nuances because investors looking to own the company over the long term need to consider the benefits of participating in the IPO versus purchasing shares on the open market immediately following the IPO. If you start with the premise that most often you are better off buying the IPO six or twelve months after the IPO, what is it about the particular opportunity that suggests you should buy it now? There are plenty of instances where buying on the IPO has been successful, so one shouldn’t dismiss the opportunity. However, one needs to consider whether the added volatility and uncertainty that comes with an IPO aligns with their objectives for a particular IPO investment.
Conclusion
Evaluating an IPO involves several considerations that span from assessing the quality of the business, its growth trajectory and visibility, what’s priced into the target valuation, and how investor sentiment can add volatility in the early stages of trading. These considerations ultimately come down to assessing whether an IPO represents an attractive investment opportunity, but more importantly, whether the IPO is the best avenue to acquire a stake in the business, or whether one is better off being patient and investing following the IPO.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not consider any investor's particular investment objectives, strategies, tax status, or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
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