HOW TO DETERMINE IF A NEW IPO IS WORTH THE RISK.Last updated on
One of the first questions new investors seem to want to ask is whether or not they should be investing in initial public offerings or IPOs, for their portfolio. An IPO, in case you haven’t learned about the specifics, yet, occurs when a formerly private business decides to take on outside investors, either by having the founders sell some of their shares or by issuing new shares to raise money for expansion, while, at the same time, listing those shares on a stock exchange or an over-the-counter market.
The appeal of IPOs is understandable. Not only are you supplying capital to the economy—money that can grow real businesses that provide tangible goods and services to consumers—but you get to enjoy the dream of repeating the experience early investors in firms such as Wal-Mart, Home Depot, Walt Disney, Dell, Tiffany & Company, Microsoft, Nike, Coca-Cola, Target, or Starbucks.
The biggest downside for the IPO investors was dealing with volatile price fluctuations along the way. It is not an exaggeration to say that there were many periods, sometimes lasting for extended lengths of time, during which the shares would fall in a quoted market by 30% to 50% or more.
Still, you may decide the risks of IPO investing are worth it. If you insist upon risking your capital and investing in an initial public offering, ask yourself a few key questions:
- If this business does not grow at a high enough rate to justify its price, what is the likely cause? What are the probabilities of those failures occurring?
- What are the competitive moats that protect the business? Patents? Trademarks? Key Executives? What is stopping some other firm from coming in and destroying the attractive economics?
- Would you be comfortable owning this business if the stock market were to close for the next five, ten, or twenty-five years? In other words, is this business model and the company’s financial foundation sustainable or is obsolescence as a result of technological advancement or lack of sufficient capital a possibility?
- If the stock falls by fifty percent due to short-term problems in the business, will you be able to continue holding without any emotional response if you can conservatively determine that the long-term potential of the company remains promising?
Finally, realize that the odds are stacked against you. IPOs, as a class, do not perform very well relative to the market. They’re already priced to perfection in many cases. This is not an area where you can do well by spreading your bets across the board and buying everything in equal weightings. There is no harm in keeping a new IPO on your watchlist, but you should exercise logic and reason before you invest in it.