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IPOs – what are they and what investors need to look out for

We take a deeper dive into the IPO process, looking at how it works, how to invest and what investors should look out for.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

An IPO, or Initial Public Offering, is when a company lists its shares on the stock market for the first time. It’s becoming more common for retail investors to invest in IPOs, so we think it’s worth looking at the nuts and bolts of how an IPO works.

This article is for people who understand the risks of investing in shares, it’s not personal advice. Investing in IPOs and individual companies isn’t right for everyone - it’s higher-risk as your investment is dependent on the fate of that company. All investments and any income they produce will rise and fall in value, so you could make a loss. If a company fails, you risk losing your whole investment. Investors should make sure they understand the companies they’re investing in, the company specific risks, and make sure any businesses they own are held as part of a diversified portfolio. If you’re not sure of an investment's suitability for your circumstances, please seek advice. Ratios and figures should not be looked at in isolation, it’s important to consider the bigger picture. Past performance is not a guide to the future.

Public vs private

Most companies start out as small, private organisations controlled by a group of founders. As the company grows, the founders offer select investors a stake in the company to raise funds. This private structure has benefits – chief among them is a lack of red tape.

At a certain point, a lot of private companies find they need to sacrifice freedom in exchange for cash. That’s when they might decide to ‘go public,’ or offer shares on the stock market for the first time through an IPO. Public companies are subject to strict reporting requirements, their structure is scrutinised by regulators, and large ‘institutional investors’ expect a say in how the company’s run.

Why IPO?

Founders and early investors give up some of their ownership in exchange for cash, usually to fund new growth or cash in on the value of their investment. Once a company has gone public, fundraising is much easier because it now has a mainline to investors on the market. Publicly traded companies are able to raise money by issuing shares in a secondary offering down the line.

However, if a company is selling new shares to pay off debt or so existing investors can exit the business, investors should be cautious. You’re buying a business which could be in trouble or that others don’t want to own. But other motivations like funding strategic acquisitions or investing in new technology are much more promising goals.

Evaluating an IPO

As part of an IPO companies have to issue a prospectus. A prospectus is one of the most detailed reports the market will have access to in a company’s lifetime. It includes financial records, projections for the future and an outline of risks. It’s the most useful tool in deciding whether or not to invest.

IPOs tend to get a great deal of media coverage, and it’s easy to get sucked into the hype. That’s particularly true if you like the brand going public and support them as a customer. If you’re considering investing in an IPO, reading the prospectus and evaluating the company’s financial health is your first step.

One particular challenge is assessing what a new company is worth without any historical pricing data to look at. That makes comparing with listed competitors a crucial tool. Let’s say Company A and Company B are in the same industry. Company B is looking to list its shares on the stock exchange so comparing something like the price-to-earnings ratio of company A is a good starting point for valuation.

A common valuation measure that divides the share price by profits per share, so will rise if prices increase or expected profits decrease.

Stands for ‘Price to Earnings Ratio’. Ratios should not be looked at in isolation.

However, lots of young companies don’t turn a profit so widely used valuation metrics, like price-to-earnings, don’t apply. In that case, a good place to start is the price-to-sales ratio (P/S).

P/S = Market Cap/Annual Sales

It’s calculated by dividing total value of all shares (market cap) by the annual sales. It tells you how much investors are willing to pay for each pound's worth of sales the company makes. The higher the ratio, the more expensive the stock is.

Again, compare it against the P/S ratio of similar businesses within the same industry. If the IPO stock has a particular advantage, like size or new technology, its sales might be worth more to you than those of competitors. One way to gauge this is to look at forecast sales, which should also appear in the prospectus.

Once you have an idea of how much you’d be willing to pay, you can make an informed decision on whether you think the IPO price is reasonable. It’s worth noting that IPOs usually give investors a price range at which the shares will debut. When you commit to buying you won’t know the exact share price, just that it will be within that range.

The IPO structure

When a company’s ready to go public, they’ll need an underwriter – typically an investment bank. Sometimes, a group of banks will come together to form a syndicate. That means they can pool their resources to underwrite an IPO that would be too big for one bank to handle alone.

The underwriter helps set the IPO price by shopping the shares around to big clients like funds and investment banks. They gauge interest in the IPO and price the shares accordingly. Once they have an idea of who’s buying, the underwriter will guarantee the number of shares to be sold at the set price. If any shares are leftover, the underwriter buys the surplus.

IPO pricing can be somewhat murky, but one approach (which roughly mirrors the general approach most underwriters take) is what’s called a Dutch Auction. In this scenario, investors submit bids for the number of shares they’ll buy and the highest price they’ll pay. The shares are awarded to the highest bidders, but all bidders pay the same price (the highest price which results in the sale of all shares). Here’s an example:

Imagine 500 shares are up for grabs:

  • Investor A bids £10 per share for 100 shares
  • Investor B bids £9 per share for 200 shares
  • Investor C bids £8 per share for 200 shares
  • Investor D bids £7 per share for 100 shares

Investors A, B and C have bidded for the 500 shares at a higher price than investor D. Therefore the underwriter will sell all the shares on offer to investors A, B and C at £8 - the highest price at which the underwriter can sell all the shares on offer. Investor D will be completely left out.

How to invest in IPOs

Investing in an IPO offers investors a way to get in at a relatively early stage. All of the stock market giants were, at one stage, privately held companies getting ready to go public. But you have to be prepared to do your research. IPOs are risky, as the companies are often unproven when they come to the market.

Investing in individual companies isn’t right for everyone. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

In the US, a wave of Special Purpose Acquisition Companies (SPAC) have hit the market. These are publicly traded companies that pool investor money to acquire a private business – essentially taking it public without the need for an IPO. This method cuts out the underwriters completely and any ordinary investor can buy a stake.

In this way investors have more access, but far less control. When SPACs collect investors’ money, they typically don’t have an acquisition target in mind. Some promise to make a purchase in a specific industry, but investors have very little say in which company they end up choosing. It’s also possible the SPAC doesn’t find a suitable target at all, in which case they return investors’ money.

IPO Alert Service

The shifting landscape of IPO investing means it’s becoming increasingly accessible.

To help you stay on top of events, our free IPO alert service will keep you up to date with the latest IPO information that HL clients can take part in.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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