In an initial public offering (IPO), a private company "goes public," making its stock available to investors to buy on a stock exchange or over-the-counter market.
IPO stock can be a valuable investment, but sometimes investors lose a lot of money. Learn about the benefits and downsides of investing in IPO stock and how to evaluate your investment.
What Is an Initial Public Offering (IPO)?
A private company that offers its shares of stock to the general public is said to be making an initial public offering. To prepare for an IPO, the company will register with the U.S. Securities and Exchange Commission (SEC), file important paperwork, and typically list on a major exchange, such as the New York Stock Exchange or Nasdaq. To invest in an IPO, individual investors can purchase shares as they become available on the public market.
The Benefits of Buying IPO Stock
Buying IPO stock can be appealing. A block of common stock bought during an initial public offering has the potential to deliver huge capital gains decades down the line. Even just the annual dividend income of a highly successful company can exceed the original investment amount, given a few decades' time.
Your investment provides capital to the economy, enabling companies that provide real goods and services to grow and expand. Learning how to buy IPO stock can lead to very attractive results when conditions are right.
Consider the value of a share of Coca-Cola purchased when the company went public. The company's initial public offering set the price of a share at $40 in 1919. More than 100 years (and many stock splits) later, an investor who bought one share in 1919 would now hold 9,216 shares. Valued at $49 per share, which was the 52-week average closing price for Coca-Cola stock as of May 7, 2021, that original investment would have grown to be worth $452,313—not counting dividends.
The Downsides of IPO Investing
The biggest downside for the IPO investors is dealing with volatile price fluctuations. It can be hard to stay invested when the value of your shares plummets.
Many stockholders don't stay calm when prices tumble. Rather than valuing the business and buying accordingly, they look to the market to inform them. However, in doing so, they fail to understand the difference between intrinsic value and price.
Not all IPOs have a happy ending. Consider Webvan, a dot-com-era grocery delivery company. In business for just three years after its IPO in 1999, Webvan lost hundreds of millions of dollars. Investors who bought in at $26 per share at the IPO (and saw growth of 58 percent the first day) and continued to hold would eventually see their shares fall to just 6 cents apiece as the company filed for bankruptcy in 2001.
The Classical Value-Investing View of IPO Investing
Benjamin Graham, the father of value investing, recommended in his book The Intelligent Investor that investors steer clear of all initial public offerings. The reason? During an IPO, the previous owners are attempting to raise capital at a premium price, which offers little chance for buying your stake at a discount.
Instead, he argued, wait for some hiccup in the business, which will cause the stock price to collapse within a few years and give an opportunity to load up on shares at a discount.
Graham’s position is one of conservative, disciplined safety. It lessens your risk of getting burned, and the average investor will likely be well served in the long run by adhering to that principle.
How to Evaluate Buying an IPO Stock
If you've decided on buying IPO stock, be sure to consider the strengths of the business itself. Ask yourself a few key questions:
- If this business does not grow at a high enough rate to justify its price, what is the likely reason? What are the probabilities of those failures occurring?
- What are the competitive moats that protect the business? Are there patents, trademarks, key executives, or some other unique factor protecting it?
- What is stopping some other firm from coming in and destroying the attractive economics?
Consider also your personal level of comfort with the business and how it is run:
- Would you be comfortable owning this business if the stock market were to close for the next five, 10, or 25 years? In other words, is this business model and the company's financial foundation sustainable? Or is obsolescence as a result of technological advancement or lack of sufficient capital a possibility?
- If the stock falls by 50% due to short-term problems in the business, will you be able to continue holding your shares without any emotional response?
Do your due diligence on the company and its prospects before plunking capital down. It may be difficult to do, as the company likely hasn't made a good deal of financial information public to that point, but it's crucial to your success.
The Bottom Line
The odds are stacked against you when it comes to a successful investment in an IPO. IPOs, as a class, do not perform very well relative to the market. They're often already priced to perfection.
Before you invest, figure out what it is you are looking for. Consider that you may need to wait patiently, perhaps even for years, for the right opportunity at the right time. Sometimes that opportunity occurs at an IPO, but more often than not, it will require discipline, timing, and research.
Frequently Asked Questions (FAQs)
How do I buy pre-IPO stock?
Before a company goes public, it might offer some discounted shares to private investors in the form of a pre-IPO placement. These are privately sold shares and thus not regulated by the SEC. They're also only available to accredited investors, so many individual investors are not able to purchase them. If you're approached to buy pre-IPO shares, be skeptical about the possibility of a scam, and do your research.
How is IPO price determined?
The process for determining an IPO price is complicated. It's done by the lead investment bank underwriting the IPO, and it's based on the company's financial state, comparable company valuations, and the sales skills of those setting the price.