Be Wary of Initial Public Offerings of Stock

By WEALTH Magazine Staff | Print This Article

Recent volatility in the stock market has dampened interest among many investors in initial public offerings of stock. But online coupon company Groupon has renewed interest in IPOs. As we post this story on Friday (11/4), Groupon has just offered its IPO. And despite some analysts’ gloomy reports on the company, this IPO has attracted lots of interest: Groupon’s stock jumped $9.52 to $29.52 in the first few hours after its IPO debuted.

But is an IPO a good opportunity for you?

The answer may not be instantly clear. Investors must step carefully when buying into a company that’s just gone public. The IPO process often is dominated by underwriters, investment banks and institutional investors that can drive up the early price to an unsustainable level.

You have to cut through the hype and be as diligent about looking into the company as you would with one that’s been public for decades.

Without an established track record or detailed earnings history to go on, that can be dicey. Still, an investor with high tolerance for risk may be tempted to try to get in early on the next Google. Shares of the Internet search leader had an initial offering price of $85 for connected investors in 2004, started on the stock market at $100, and have been trading lately around $600.

The Associated Press recently offered five things investors need to know about IPOs before getting involved:

1. Learn the lingo. There are other key terms to know besides IPO and “going public,” which is shorthand for a company issuing stock to the public for the first time.

For example, the “underwriter” is an investment bank or other financial firm that works with the company to determine a stock’s offering price, buys shares from the issuer and sells them to investors. The “aftermarket” is where most investors purchase shares—on the open stock market. A “red herring” prospectus outlines the issuing company’s history and business plan. And a “greenshoe option,” or over-allotment option, gives underwriters the right to sell investors more shares than planned if demand is high.

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2. It’s difficult to get in. Average investors typically can’t get in on an IPO at the offer price. Underwriters generally allot those shares to money-management firms and other favored clients. Having a full-service brokerage account with one of the underwriters helps, but it’s still no guarantee.

3. First-day investing is like rolling the dice. You’ll almost certainly pay more for a stock on its first day of open trading than those who bought in at the offer price. During the last decade, the first market price of newly issued stocks has been an average 11 percent higher than the offer price. Beyond that, though, the price is wildly unpredictable for the first couple of days.

4. Sales are key. Investors shouldn’t necessarily rule out companies that have losses on their pre-IPO income statements. Focus instead on revenue or sales. But don’t confuse sales growth with profitable growth, as investors did in the speculative bubble before many dot-com companies went bust in 2000.

5. The long-term outlook often is poor. IPOs aren’t usually a good match for the buy-and-hold investor, because in the long run they underperform the market. The trend for a typical IPO over the years has been for its stock price to be higher after six months and then gradually decline to below the offering price within two to three years. About 20 percent of these companies fail within five years.

Finally, if you’re thinking about getting in on Groupon, you might check out the Motley Fool website, which recommends five other stocks instead of Groupon.

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