Analyzing IPOs

When it comes to pricing a financial asset traded on the market, the basic laws of economics apply: its value is set by the forces of supply and demand. From a high level, newly issued stocks are no exception to this rule—they sell for whatever price a person is willing to pay. The best analysts who do this are stock evaluation experts, who figure out what a stock is worth and will capitalize on the market if the stock is trading at a discount (lower than they believe it is worth) to purchase shares.

Initial public offerings (IPOs) are unique stocks because they are newly issued. The companies issuing IPOs have not been traded previously on an exchange and are less thoroughly analyzed than companies that have an established trading history. Thus, there are differing opinions on the valuation and funding of IPOs. Some believe the lack of a historical share price performance provides a buying opportunity, while others think that IPOs are considerably riskier than stocks because they have not yet been analyzed and scrutinized by the market. A number of methods can be used in analyzing IPOs; because these stocks lack a demonstrated past performance, analyzing them using conventional means is tricky. So let's dive into how to analyze an IPO.

Evaluating a New IPO

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 new issues tend to appreciate considerably in price as soon as they become available on the market. Because the demand for these issues is higher than supply, the price of oversubscribed IPOs tends to increase until supply and demand reach equilibrium. If you're an investor who does not get the first right to buy new issues, there's still an opportunity to make money, but it involves substantial work analyzing the issuing companies. Here are some points to consider when analyzing IPOs to buy:

  1. Why has the company elected to go public?
  2. What will the company be doing with the money raised by the IPO?
  3. What is the competitive landscape in the market for the business' 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 available on the company's Form S-1, which is required reading for an IPO analyst. After reading the company's S-1, an analyst will have an understanding of the characteristics of the business and the operations. Given these characteristics, the analyst can determine a reasonable valuation for the company. Dividing this number by the number of shares on an offer shows a reasonable price for the stock. Other valuation strategies include comparing the new issue to similar companies already listed on an exchange to determine whether or not the IPO price is justified.