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
Nasdaq:VRAZ
$8.00 $1.87 -76.63 No
Comverge Inc.
Nasdaq:COMV
$18.00 $13.28 -26.22 No
Metro PCS Communications
NYSE:PCS
$23.00 $19.95 -13.26 Yes
Simcere Pharmaceutical
NYSE:SCR
$14.50 $14.60 0.70 Yes
Cinemark Holdings Inc.
NYSE:CNK
$19.00 $14.11 -25.74 No
OceanFreight
Nasdaq:OCNF
$19.00 $25.44 6.44 No
Orexigen Therapeutics
Nasdaq:OREX
$12.00 $8.31 -30.75 No
Edenor SA
NYSE:EDN
$17.00 $16.88 -0.71 Yes
Pharmasset Inc.
Nasdaq:VRUS
$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.

Related Articles
  1. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
  2. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  3. Home & Auto

    Avoiding the 5 Most Common Rent-to-Own Mistakes

    Pitfalls that a prospective tenant-buyer could encounter on the road to purchase – and how not to stumble into them.
  4. Home & Auto

    Renting vs. Owning: Which is Better for You?

    Despite the conventional wisdom, renting might make more financial sense than you think.
  5. Active Trading Fundamentals

    The Companies of Peter Theil's Founders Fund

    Learn about the major public companies that Peter Thiel has invested in and companies that are on the verge of going public at multibillion-dollar valuations.
  6. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
  7. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
  8. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  9. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  10. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
RELATED TERMS
  1. Theta

    A measure of the rate of decline in the value of an option due ...
  2. Equity

    The value of an asset less the value of all liabilities on that ...
  3. Derivative

    A security with a price that is dependent upon or derived from ...
  4. Security

    A financial instrument that represents an ownership position ...
  5. Series 6

    A securities license entitling the holder to register as a limited ...
  6. Internal Rate Of Return - IRR

    A metric used in capital budgeting measuring the profitability ...
RELATED FAQS
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!