Initial Public Offerings - they're one of the most misunderstood investments available. In theory, they provide growth capital for private businesses. In reality, they often do little more than line the pockets of those who got in before the regular investors could - the owners, the founders, directors and CEOs. They call this the "exit" strategy.

IPOs, along with other cash-out options such as selling to another company, are a cornerstone of investment banking. Wall Street firms receive generous fees for finding investors to buy the shares made available in the IPO. In most cases, founders and other company elites put some or all their stock into the offering. It's great for them, not so great for the buyers of the IPO. (To learn the investment bank's role in an IPO, read The Rise Of The Modern Investment Bank.)

By The Numbers
Nine companies went public in April 2007. Here's a table showing each stock, its performance for the past year, as well as whether it was making money at the time of the IPO.

Company IPO Price May 13/08 Price Return (%) Positive EPS
Veraz Networks
$8.00 $1.87 -76.63 No
Comverge Inc.
$18.00 $13.28 -26.22 No
Metro PCS Communications
$23.00 $19.95 -13.26 Yes
Simcere Pharmaceutical
$14.50 $14.60 0.70 Yes
Cinemark Holdings Inc.
$19.00 $14.11 -25.74 No
$19.00 $25.44 6.44 No
Orexigen Therapeutics
$12.00 $8.31 -30.75 No
Edenor SA
$17.00 $16.88 -0.71 Yes
Pharmasset Inc.
$9.00 $16.45 82.78 No

The evidence is clear, with the exception of rock-star IPOs like VISA (NYSE:V), there is very little demand for initial public offerings. For the first three months of 2008, there were half as many IPOs compared to the same time in 2006. In the first two months of this year, more than 30 were shelved due to a lack of interest. I can see why with results like these.

When did the IPO market become the place for shaky finances and questionable business models? It used to be that you went public because your company was a pillar of success, and you looked to the public markets to raise the funds necessary to get to the next level, not to make the big score. (Learn more in our related article The Murky Waters Of The IPO Market.)

Five Questions To Ask

  1. Was the company making money before the IPO? The most important thing in my mind when investing in IPOs is fundamentals. If the prospectus shows a business that's not making money, I'd pass. You're not a venture capitalist.

  2. What valuation metrics are being used? Some, like IPO research specialist Renaissance Capital, use traditional metrics like price-to-sales, price-to-earnings and enterprise value-to-cash flow to compare an IPO to its peers. Others, like Morningstar, prefer to use a discounted-cash-flow model to arrive at an appropriate valuation. (For more information, read Relative Valuation: Don't Get Trapped.)

  3. Do the managers, owners and board have the interests of new shareholders at heart? It could be that they are simply looking for the big payoff. If the founders are selling more than 30% of the shares offered in the IPO, you can be fairly sure they aren't concerned about corporate governance.

  4. What's happening to the proceeds? If it's just to cash out, then forget it. A good example of this is Lululemon (Nasdaq:LULU), the yoga-wear company that went public in 2007. Its officers and directors sold 14 million of the 18.2 million shares in the offering. That's 77% of the total. The success or failure of the expansion was less important because, for them, the money had already been made.

  5. Who is underwriting the IPO? A big firm like Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) or Merrill Lynch (NYSE:MER) will ensure the shares get into the hands of the most reputable institutional investors, indicating the deal is a good one. A good deal equals a higher offering price.

If You Must Buy...
The performance of many stocks post-IPO is mediocre at best. Statistics gathered by Florida finance professor Jay Ritter for the years 1970 to 2003 show that, on an annual basis over five years, IPOs under-perform similar sized public companies by 4.1%. In another study co-authored by Ritter and published in the Journal of Finance, 34% of all IPOs between 1980 and 2001 had earnings per share (EPS) less than zero.

Interestingly, first-day returns for companies with EPS less than zero were 31.4%, which compares to 12.5% for those making a profit. The moral of the story: if you must buy into an offering, have the good sense to sell sometime during the first day of trading.

Bottom Line
All the statistics indicate that IPOs are generally poor investments. If you insist on investing in one, make sure you do your homework. The last thing you want to do is make a founder, director or CEO rich without any reciprocation.

For everything you need to know, check out our IPO Tutorial.

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