To a certain type of investor, few scenarios sound more satisfying than the idea of getting in on the ground floor of an investment opportunity and then watching said investment rise in price while the latecomers vie for the dwindling and ever more precious table scraps. People want to stake the gold claim on the previously overlooked part of the Klondike, drill the productive wildcat well in the Permian Basin or be Steve Jobs’s and Steve Wozniak’s third partner. Doing this involves slightly more work and more risk than finding a winning lottery ticket on the street, but without an appreciably better chance of success.

Among a few other reasons, this innate covetous desire to move to the front of the line is why the underwriting industry attracts the kind of people that it does – and why initial public offerings (IPOs) attract such attention.

An initial public offering (IPO) is the process by which a private company becomes publicly traded on a stock exchange. Once a company is public, it is owned by the shareholders who purchase the company's stock. Every public corporation in existence had to start trading at some point, which is to say, initiate an IPO.

The only real exposure many retail investors have to the IPO process occurs a few weeks prior, when media sources inform the public of the offering. How a company gets valued at a particular share price is relatively unknown, except to the investment bankers involved and those serious investors who are willing to pour over registration documents for a glimpse at the company's financials. (For some quick background, see "IPOs for Beginners.")


How An IPO Is Valued

Where to Begin

Which indirectly leads to the first rule of effective IPO analysis: analyze. Or to elaborate, do not be swayed by publicity and exposure. Loading up on Groupon, Inc. (GRPN) just because your friends use the service daily and the company spokespeople give entertaining interviews on CNBC is asking to be poor. Like any investment, you need to research, even scrutinize, before committing money. Spending a couple of hours hovering over prospectuses and financial statements is not tedium, it is leveraging a little bit of time for the potential of a large monetary payoff. Doing anything less isn’t investing, it’s wagering.

Even if one of the richest private corporations were to go public, say Cargill or Koch Industries, it wouldn’t be enough to just buy shares as soon as they became available and then assume the rocket ride will continue. As the old-but-true saw goes, you make your money going in. A lucrative but overpriced moneymaker might not be as good a deal as its mildly profitable but much less expensive counterpart.

The problem, of course, is that incipient IPOs, by virtue of being currently private companies, don’t have long histories of disclosing financial statements publicly. But disclose they do, in much the same manner of established public companies. Every one produces balance sheets, income statements and cash flow statements – all the usual culprits.

Quantitative Components of IPO Valuation

Like any sales effort, a successful IPO hinges on the demand for the product you are selling – a strong demand for the company will lead to a higher stock price. Strong demand does not mean the company is more valuable; rather, the company will have a higher valuation. In practice, this distinction is important. Two identical companies may have very different IPO valuations, merely because of the timing of the IPO as compared to market demand.

An extreme example is the massive valuations of IPOs at the 2000 peak of the tech bubble compared to similar (and even superior) tech IPOs since that time. The companies that went public at the peak received much higher valuations – and consequently much more investment capital – merely because they launched when demand was high. (Find out how companies can save or boost their public offering price with "Greenshoe Options: An IPO's Best Friend.")

Another aspect of IPO valuation is industry comparables. If the IPO candidate is in a field that already has comparable publicly traded companies, the IPO valuation may be linked to the valuation multiples being assigned to competitors. The rationale is that investors will be willing to pay a similar amount for a new company in the industry as they are currently paying for existing companies.

In addition to viewing comparables, an IPO valuation depends heavily on the company's future growth projections. Growth is a significant part of value creation, and the primary motive behind an IPO is to raise more capital to fund further growth. The successful sale of an IPO often depends on the company's plans and projections for aggressive expansion.

Spend less than a minute looking up the company’s financial disclosures, contrast that with the company’s expected theoretical initial book value (IPO price times number of shares issued), then determine for yourself whether company management and the underwriting banks have overshot, undershot, or assessed accurately.

Qualitative Components of IPO Valuation

Some of the factors that play a large role in an IPO valuation are not based on numbers or financial projections. Qualitative elements that make up a company's story can be as powerful – or even more powerful – as the revenue projections and financials. A company may have a new product or service that will change the way we do things, or it may be on the cutting edge of a whole new business model. Again, it is worth recalling the hype over internet stocks back in the 1990s. Companies that promoted new and exciting technologies were given multi-billion-dollar valuations, despite have little or no revenues. Similarly, companies undergoing an IPO can bulk up their story by adding industry veterans and consultants to their payroll, giving the appearance of a growing business with experienced management.

Herein rests a harsh truth about IPOs; sometimes, the actual fundamentals of the business take a back seat to the marketability of the business. It is important for IPO investors to have a firm understanding of the facts and risks involved in the process, and not be distracted by a flashy back story. (For more, see "The Ups and Downs of Initial Public Offerings.")

Facts and Risks of IPOs

The first goal of an IPO is to sell the pre-determined number of shares being issued to the public at the best possible price. This means that very few IPOs come to market when the appetite for stocks is low – that is, when they're cheap. When equities are undervalued, the likelihood of an IPO getting priced at the high end of the range is very slim.

So, before investing in any IPO, understand that investment bankers promote them during times when demand for stocks is favorable. When demand is strong and prices are high, there is a greater risk of an IPO's hype outstripping its fundamentals. This is great for the company raising capital, but not so good for the investors who are buying shares. (IPOs have many unique risks that make them different from the average stock. For more, see "The Murky Waters of the IPO Market.")

The IPO market basically died during the 2009-2010 recession because stock valuations were low across the market. IPO stocks couldn't justify a high offering valuation when existing stocks were trading in value territory, so most chose not to test the market.

The Bottom Line

Valuing an IPO is no different than valuing an existing public company. Consider the cash flows, balance sheet and profitability of the business in relation to the price paid for the company. Sure, future growth is an important component of value creation, but overpaying for that growth is an easy way to lose money.

Most IPOs render their investors disappointed. But again, that’s reflective of the market as a whole, which is comprised of nothing but IPOs of varying vintages. The intelligent investor (with apologies to Benjamin Graham) understands that the fundamentals of the game transcend the particular investment. Buy underpriced assets. Sell, or eschew, overpriced ones. Then be patient, then profit.