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Investing in IPOs – a buyer's check list

Here are some of the key questions investors should ask before investing in an IPO.

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 Initial Public Offering (IPO) is when a company sells its shares on the stock market for the first time. Typically, they’re surrounded with a great deal of once-in-a-lifetime marketing fanfare. But for investors, deciding whether or not to buy an IPO stock should be exactly the same as deciding whether to buy any other investment.

It’s important to take into account a number of things, but ultimately you’re trying to determine whether the stock is reasonably valued. Unlike shares that have been trading for years, IPO stocks don’t have as much widely-published information. This makes it harder to make an informed decision about whether an IPO stock is right for your portfolio. It’s possible, though, with a bit of leg work.

IPOs – what are they and how do they work

This is not personal advice. If you're not sure if an investment is right for you, please seek advice. The value of all investments will fall as well as rise, so you could get back less than you invest. All investments made into an IPO or new issue should be done solely on the basis of the information provided in the Prospectus and any other supplementary documentation.

The sniff test

The first and most important step in the process is what we affectionately call, ‘the sniff test.’ Assessing IPO stocks takes a good deal of time and effort, so before committing to the process, it’s worth answering a simple question to see if it’s worth the effort:

Why is this company selling shares?

If the answer is something like ‘to fund future growth’, it smells ok.

Where the money raised in an IPO ends up is important. If it’s earmarked for acquisitions, new technology or any other investment that will help a company grow, that’s a good sign. If it’s primarily to give founders and early investors a chance to exit the company by selling some of their shares, there’s an unmistakable foul odour.

It can make sense that some early investors might want to reduce how much they have invested, but a mass exodus is a red flag that shouldn’t be ignored. Do you really want to buy an unproven company when those who know it best are heading for the door?

Significant sales by previous private equity owners is a particular warning sign. Private equity owners often have a very short investment horizon – just 5 years is common. Private equity owned companies are often loaded up with debts before a sale – maximising returns for the seller but increasing the risk for investors in the IPO.

What IPO proceeds are being used for, and almost everything else discussed in this article can be found in a company’s prospectus. All companies coming to market issue one, and they contain everything from an overview of potential risks to recent financial data. Investors should read them in detail before making an investment decision.

Tips

  • Companies raising money to fund growth is a good sign, giving early investors an exit is a red flag
  • Be wary of private equity IPOs – they’re smart, professional investors and they don’t like giving other people a bargain
  • Always read the prospectus

Avoid the rush

Despite what the marketing might have you believe, an IPO isn’t your only chance to buy shares in a company. Once it’s listed, you’ll be able to trade the share any time you want, every working day. The IPO is not a once in a lifetime opportunity.

That means you can take a wait-and-see approach.

This is particularly useful if you’re worried the IPO could be a fire-sale for early investors. Typically, pre-IPO shareholders are prohibited from selling further shares for 90 to 180 days in what’s called a lock-up period. Waiting for the lock-up to expire before buying is a good strategy if you’re not sure about the reason for the IPO.

Take US tech group Palantir, which IPO’d in 2020, as an example. While the stock initially had a good run, it began to deteriorate in the lead up to 18 February this year, the end of the lock-up period. Some of its largest investors admitted they were planning to offload holdings as soon as they were allowed. The firm’s share price has fallen roughly 9% since the lock-up’s expiry*. It wasn’t enough to knock the shares back to their IPO price, but painful for later investors nonetheless.

Palantir Technologies - share price

Past performance isn’t a guide to future returns. Source: Refinitiv Datastream, to 22/04/2021.

*From 18/02/2021 to 22/04/2021.

Tips

  • An IPO isn’t a once in a lifetime opportunity. Once a company is listed you can buy it any time. Don’t be rushed into a decision
  • Wait for the lock-up to expire if you’re worried about a company’s motives for listing

Valuing an IPO

If the IPO passes your sniff test, it’s time to crunch some numbers.

Investors have easy-to-access valuation ratios for listed companies. You can find price-to-earnings (P/E) ratio for most UK stocks on our website for example. But these ratios aren’t published for companies about to IPO, so investors will have to do a bit of maths themselves.

The type of IPO will determine the most appropriate valuation metrics to use. If the company is profitable, the price-to-earnings (P/E) ratio is a useful starting point. It tells you how much investors are willing to pay for each pound’s worth of profits.

To work out an appropriate starting valuation, investors can look for similar listed companies in the same industry. As a rule of thumb, investors can expect that the unproven firm is riskier than its listed peers. Theoretically, it should come with a lower P/E ratio.

If the company isn’t yet profitable, as is often the case with tech companies or start-ups, the price-to-sales ratio (P/S) is the next best port of call. This tells you how much the market is willing to pay for each pound’s worth of sales. As with the P/E ratio, comparing to competitors that are listed is a good way to get a sense of an appropriate IPO price.

A good example of this is the Hut Group, a consumer brands retailer that debuted on the London Stock Exchange in 2020. The group wasn’t profitable at the time of its IPO, so investors would’ve had to use sales to value the group. Its business doesn’t fit neatly into one category – it makes most of its sales through direct-to-consumer beauty and health brands, but also offers e-commerce solutions to brand partners. That means companies like Ocado, Boohoo and ASOS all make for worthwhile comparisons.

As you might expect, for a relatively new, unprofitable business the Hut Group’s price-to-sales ratio values it below its competitors.

Price/Sales ratios for various UK delivery groups at time of The Hut Group IPO

Past performance isn’t a guide to the future. Source: THG Prospectus, Refinitiv 23/04/2021.

Tips

  • Always compare the IPO’s valuation to listed peers to find a fair price
  • If the company is profitable, use P/E as a starting point
  • If there are no profits yet, P/S can be used as a starting point instead

What have others paid for their shares?

Before listing on the stock market, private companies fundraise by asking institutional investors like venture capitalists and hedge funds for money. The amount they’ve paid in exchange for their stake in the company can be useful information. The valuations of recent fundraising rounds should be listed in the prospectus, and it’s particularly worth looking at the most recent round of funding.

If the company hasn’t been around long, you can also use a prospectus to get an idea of what other early investors paid for their shares in the company. This information is useless if the company is ten years old, but for a young company it might be a useful insight.

To calculate, you need to know how many shares are outstanding and divide them by what they were worth at the time of issue. Both can be found in a company’s prospectus.

Take Deliveroo, for example. According to the group’s prospectus, pre-IPO, investors held roughly 6.7bn shares worth £1.3bn. That puts the price per share at roughly 19p. The IPO priced shares at more than 20x that.

You should always expect early investors’ shares to come in below market price, but it’s potentially informative nonetheless.

Tip

  • Get an idea of what other investors have paid for their shares

That extra something

The IPO process is basically a marketing exercise designed to drum up as much interest in buying a company’s shares as possible. That makes sense – the company is trying to raise money, so it wants a lot of attention to drive up demand and, in turn, the price. But hype is bad for investors, who will have to pay a higher price simply because more people are suddenly paying attention.

For that reason, we think calculating a reasonable value for the stock before looking at the official price target range is essential.

Using the metrics above, investors can get an idea of what they think is a fair price. But calculating value is more than a mathematical exercise – there are other factors that can drive value higher or lower. This is where investing becomes more art than science. Is the company worth a premium? Only you can decide.

Tips

  • Who’s leading the company? Do they have a particular expertise in this field?
  • How long has it been operating? A company that’s been successful for 10 years is likely to be more valuable than one that’s just 3 years old.
  • Do they have any significant competitive advantages?
  • What are the growth prospects? How easily can they scale up their operations?

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.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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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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