How does an IPO get valued? What are some good methods for analyzing IPOs?

By Rob Renaud AAA
A:

The price of a financial asset traded on the market is set by the forces of supply and demand. Newly issued stocks are no exception to this rule - they sell for whatever price a person is willing to pay for them. The best analysts are experts at evaluating stocks. They figure out what a stock is worth, and if the stock is trading at a discount from what they believe it is worth, they will buy the stock and hold it until they can sell it for a price that is close to, or above, what they believe is a fair price for the stock. Conversely, if a good analyst finds a stock trading for more than he or she believes it is worth, he or she moves on to analyzing another company, or short sells the overpriced stock, anticipating a market correction in the share price.

Initial public offerings (IPOs) are unique stocks because they are newly issued. The companies that issue IPOs have not been traded previously on an exchange and are less thoroughly analyzed than those companies that have been traded for a long time. Some people believe that the lack of historical share price performance provides a buying opportunity, while others think that because IPOs have not yet been analyzed and scrutinized by the market, they are considerably riskier than stocks that have a history of being analyzed. A number of methods can be used to analyze IPOs, but because these stocks don't have a demonstrated past performance, analyzing them using conventional means becomes a bit trickier. (For more information, check out our IPO Tutorial and The Murky Waters Of The IPO Market.)

If you're lucky enough to have a good relationship with your broker, you may be able to purchase oversubscribed new issues before other clients. These tend to appreciate considerably in price as soon as they become available on the market: because demand for these issues is higher than supply, the price of oversubscribed IPOs tends to increase until supply and demand come into equilibrium. If you're an investor who doesn't get the first right to buy new issues, there's still an opportunity to make money, but it involves doing a substantial amount of work analyzing the issuing companies. Here are some points that should be evaluated when looking at a new issue:

1. Why has the company elected to go public?
2. What will the company be doing with the money raised in the IPO?
3. What is the competitive landscape in the market for the business's products or services? What is the company's position in this landscape?
4. What are the company's growth prospects?
5. What level of profitability does the company expect to achieve?
6. What is the management like? Do the people involved have previous experience running a publicly-traded company? Do they have a history of success in business ventures? Do they have sufficient business experience and qualifications to run the company? Does management itself own any shares in the business?
7. What is the business's operating history, if any?

This information and more should be found in the company's S-1 statement, which is required reading for an IPO analyst. After reading the company's S-1, you should have a pretty good understanding of the characteristics of the business and the operations at the company. Given these characteristics, find out what you believe to be a reasonable valuation for the company. Divide this number by the number of shares on offer to find out what's a reasonable price for the stock. Other valuation strategies could include comparing the new issue to similar companies that are already listed on an exchange to determine whether or not the IPO price is justified.

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