This is a hot year for IPOs (initial public offerings) and I get a lot of questions about them, particularly this year! IPOs can seem sexy, but investors need to exercise caution.
In today’s video, I’m discussing:
- Whether an IPO is a good investment.
- 4 qualities you should look for in an IPO and if an IPO makes sense in the first place. Spoiler, I’m not a huge fan of IPOs…I’ll explain why.
- A very little-known fact about IPOs. This is extremely important to know!
- Things you will want to think about the next time you hear about a hot IPO.
Click here to watch the full video or read the full video transcript, below.
Retirement Q&As: IPOs
IPOs have been dormant for the last several years and suddenly there’s been an explosion! Uber, Lyft, Pinterest, Slack, Levi Strauss – lots of companies that are going public this year and issuing stock for the first time. It’s kind of exciting, there’s a lot of buzz!
There are also a lot of questions around IPOs and today I’m going to cover in detail what you should know if you’re considering investing in one.
QUESTION #1 – Is An IPO A Good Investment?
Let’s take the 30,000 ft view here and ask the question that needs to be asked. Is an IPO a good investment?
The answer is…it depends. The thing to realize about IPOs is that there’s a lot of hype around them. When most companies go public for the first time, they’re in this high growth phase. There’s a lot of clamor, there’s a lot of people super excited because who doesn’t want to get in on the ground floor of the next Apple, Google or Facebook?
An IPO Flop – Featuring Groupon
Groupon went public at an IPO price of $20 a share. A lot of people were already using Groupon, it seemed like a great investment. A multitude of people jumped in and bought Groupon right after it went public. The stock went from $20 a share to $26 a share, in the very first day of trading.
About a year later, the stock was trading at approximately $3 a share. That is not a rare occurrence. It happens more frequently than you might realize with IPOs because once the hype and excitement is gone, reality sets in.
The reality with Groupon is that it was not worth a $26, $25 or $20 share price. The stock was worth what the market will pay for it based on all the fundamentals. And the fundamentals say that Groupon is only worth about $3 to $5 a share.
Question #2 – What Qualities Should I Look For In An IPO?
The four qualities that you’ll want to look for in an IPO are:
- Revenue: With revenue, we want to look for growing revenues.
- Profitability: One of the major problems with investing in IPOs and why I’m not interested in them most of the time, is because when companies go public for the first time, they are usually losing money every year. Amazon was a perfect example of this for a long time. They had negative earnings and they were losing money every year. Of course, we know why Amazon was losing money, they were reinvesting in planning to take over the world!
- Price-To-Earnings Ratio: The other metric that’s related to profitability is the price to earnings ratios. You look at the IPO price and divide by earnings per a share. You want to know whether this IPO is overvalued or undervalued, if it’s expensive or cheap.
- Debt-To-Capital Ratio: The last metric that is important to look at is the debt-to-capital ratio. How much debt the company has relative to its total capital.
The key takeaway with this, is that you want to do your homework. If you would have done that with a company like Groupon, you would have seen lots of fruits from just waiting on the sidelines.
Question #3 – Why Does Timing Matter With An IPO?
The last thing I want to talk about, as it relates to IPOs, is that timing matters and here’s why. There are a lot of people out there who invest in IPOs because they want to flip it. They want to make a good profit, they’re going to get in and get out right away. As a result, in those early days and weeks of trading, the stock can be like a crazy roller coaster ride because there’s a lot of activity, there’s a lot of buying and selling going on.
Just know you’re not going to get the IPO price. They’re going to issue the IPO to whomever gets the shares, usually company insiders will get the IPO price. Then, after it starts trading, you must get in right away to hopefully get something close to the IPO price.
The second point I want to make about timing, and this is very important if you’re going to invest in IPOs, you need to know when the lockup period for that IPO ends. Let’s say I’m CEO of some company that goes public and I’m issued 100,000 shares of stock. There’s a lockup period after the IPO starts trading where I cannot sell my stock. I must wait a certain number of months. Usually it’s anywhere from 3 to 24 months.
If you think about it, it makes a lot of sense because it prevents the insiders of the company from just cashing out their shares immediately when the stock goes public, which could really cause the stock to drop hard.
Is An IPO Right For You? – What You Need To Consider
First, ask yourself is an IPO a good investment? Does it make sense for me? IPOs are very speculative by nature and so you want to be very careful. Next, you want to be disciplined in what you look for and look for those four qualities that I mentioned. And Lastly, understand timing and how timing works so you don’t get burned when buying an IPO.
The last thing I want to mention that is super important about IPOs is that because they’re speculative in nature, it’s very important that you don’t have more than 1% to 5% of your portfolio that’s earmarked and dedicated for IPOs. If you want to play around, go to Vegas with your money and buy IPOs, that’s totally fine. Just make sure that you’re not putting all your chips on the table. Because if the IPO goes south, which commonly happens, you want to make sure that it’s not going to be devastating for you, your portfolio or your retirement.