Things to Know: IPOs

1383766882000-AP-Wall-Street-Twitter-IPO-001The past few years have seen popular internet companies LinkedIN, Facebook and (most recently) Twitter go from startups to multi-billion dollar public companies.  Not surprisingly, I frequently get questions about IPOs and whether or not it is worth investing in these young companies.

When considering these types of stocks, the first key is to understand that a transformative company doesn’t necessarily mean it will be a great investment.  High profile IPOs typically have great interest because their products have impacted our lives.  But it is often the case these firms are unprofitable and sell their potential profitability to investors.  Symbolically, these companies hope to achieve an opening “pop” in their stock price the first day they are listed.  The dirty truth is that the price movement on day one is usually the result of factors unrelated to a company’s fundamentals.

So what then causes stocks to jump higher when they are first listed? First and foremost is investor enthusiasm.  Certain companies stir our emotions because we recognize how they have transformed our lives, but again this does not guarantee a profitable company; yet we will buy the stock regardless.  During what is called a road show, company executives speak to potential investors, typically large mutual funds and institutional investors, about the merits of investing in their company.  During this time they work to gauge the interest and potential demand for their stock.  After this, they set the number of shares to be sold and at what price.

The company wants to raise as much capital as possible so they can reward earlier investors and potentially invest in the business. Symbolically however, they want to see their stock price go up. They believe a strong opening day is a symbol of future success.  One way they do this is by releasing fewer shares than the public demands.  This results in buyers competing for limited supply, pushing up the stock price.  They also limit the supply by restricting employees from selling their shares, commonly called a “lock up.”  Beware of IPOs where the vast majority of shares are restricted from trading for a period of time.  When these periods expire it is common to see the market flooded with supply resulting in a lower price per share.  If you believe in the long-term ability of the company, this can be a good time to begin investing in these types of companies!

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