The stock market has recovered as of late, but initial public offerings have not. Only nine companies came public in the first quarter of this year, the lowest number since the first quarter of 2009, according to The Wall Street Journal.
But either the IPO market will recover soon or the recent stock market gains will slow down. If it is the former, then investors need to get ready and understand some of the challenges in investing in an IPO. Although the right IPO can offer steady, long-term profits, finding the right one means you have to do a good bit of research.
Here are five things that all investors should do when assessing an IPO and determining whether it worth buying.
1. Read the Prospectus
Yes, the prospectus for any upcoming IPO should be taken with a block of salt. It is written by the company, which has every incentive to gloss over its weaknesses and tout how successful it will be.
But there is still plenty of valuable information that a keen-eyed investor can find in the prospectus. Companies cannot explicitly lie about their profit or revenue, and it is possible to find numbers that indicate a company is not as sound financially as it claims.
One of the biggest things to look out for is what the company plans to use the raised money for. If the company talks about expansion or further research, that is good. If the company talks about paying off debts, that can be a problem. Above all, the prospectus will show what the company's future vision is, and it will be up to you to determine whether that vision makes sense.2. Check the CEO's Background
In order to check a company's future vision, you have to see what the CEO wants and that he has a track record of carrying out his plans. A good CEO or management team can make all the difference between success and failure. A good executive can get better underwriters for the IPO and ensure that the long-term goals of the company are being carried out. This is why it's always a good idea to run a background check on the CEO. Search the Web for information about the executive. This may involve using a Web site that provides background checks.
But having a hot-shot executive is not enough. A good CEO is important, but a good business idea with a chance of long-term success is also crucial.
3. Understand That IPOs Are Not Get-Rich-Quick Stocks
Even in this poor IPO market, the buzz around past successful IPOs like Facebook and Google (now Alphabet) has sustained a dangerous myth. IPOs are commonly perceived as a way for investors to get in on the ground floor of a new stock and get fabulously rich very quickly as the new stock takes off.
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Sure, this can happen in a few cases, and it's true that Facebook and Google have appreciated dramatically since their IPOs. But it's important to remember that that Facebook sold off in the wake of its public market debut, and it took more than a year for its share price to exceed its opening level. That's hardly "quick."
In hindsight, the success of these companies and their stocks may now seem inevitable. But there were plenty of skeptics when they went public, and their success wasn't a foregone conclusion back then.
It also easy to forget about all those stocks that might have seemed like equally compelling bets but are now languishing at significantly lower levels than when the camp public. Does Zynga ring a bell? How about Groupon? Or Pandora? The list goes on and on.
There's another problem with that myth. If you buy at the IPO, you're not on the ground floor. You've been preceded by other investors who can include management, employees, private equity firms and venture capital. This is where it's important to do your research. It's quite common for early investors to want to cash out after an IPO in order to book some profits and diversify their investments. And that's OK, if the company has solid long-term prospects. But do your best to ensure that the real goal of the IPO is not allowing early investors to cash out on a business idea with sketchy chances of long-term success.
Do not view IPOs as a way to get rich quick. Look for IPOs that are solid businesses with long-term stability.
Those other investors may have actually gotten in on the ground floor, but newly public stocks have lock-up periods that forbid insiders from selling their stocks for a specific period.
As tempting as it may be to buy a stock at or just after the IPO, it is often better to wait until that lock-up period expires. If the insiders hold onto their shares, that means they are confident in it and you may want to invest. If they sell, that can be a warning bell.5. Check to See Whether the IPO Has Been Delayed
In this IPO market, several companies have delayed IPOs in the past year. This includes Albertson's, which delayed its IPO in October amid market volatility.
While it is possible that a company is just waiting for market conditions to improve, you should view postponements as red flags. They can be signs of hidden weaknesses. If a company delays its offering multiple times, that should be particularly worrisome.
IPOs carry enough risk already. If a company delays its IPO, give it a very hard look.