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IPO meaning: Initial Public Offering
A company that decides to go public via an IPO can be an excellent chance to buy a good company early. However, you can also get caught out when they are overpriced. This guide is all about the meaning of IPOs and how to spot the good ones.
Big ideas
- An IPO is a public company listing, meaning that all investors can gain access, not just institutions and connected HNW investors.
- IPOs can be volatile and risky, so they should be carefully considered. Day traders get involved just to flip shares on the first day of trading.
- An IPO can be viewed as an exit strategy for the initial investors looking to cash out on their initial investment. Most IPOs stocks deliver negative returns yearly, but the average returns tell a different story.
An IPO occurs when a company lists its stock for public trading on an exchange such as the Nasdaq, NYSE, or LSE. It opens the doors to outside investors and increases the level of investment in the company.
However, the question remains as to why a private company would make shares available to the public, given that it comes at such a high cost. Let’s look at the Initial Public Offering (IPO) and see what it offers.
However, the question remains as to why a private company would make shares available to the public, given that it comes at such a high cost. Let’s look at the Initial Public Offering (IPO) and see what it offers.
What is an IPO?
DEFINITION
IPO stands for Initial Public Offering.
It is the process by which a private company offers shares of its stock to the public for the first time to raise capital and become a publicly traded company.
It is the process by which a private company offers shares of its stock to the public for the first time to raise capital and become a publicly traded company.
When a company decides to go public, it typically works with investment banks and other financial institutions to underwrite the offering and determine the initial price for the shares. The company will then register the IPO with the Securities and Exchange Commission (SEC) in the US or the Financial Conduct Authority (FCA) in the UK.
Once the appropriate regulatory authority approves the registration statement, the company can market the IPO to potential investors. The company will typically conduct a roadshow, presenting its business to institutional investors and others interested in buying shares.
Once the appropriate regulatory authority approves the registration statement, the company can market the IPO to potential investors. The company will typically conduct a roadshow, presenting its business to institutional investors and others interested in buying shares.
How an IPO works?
On the day of the IPO, the company's shares are available on a stock exchange, such as the New York Stock Exchange (NYSE) or the NASDAQ. Big international IPOs usually occur in the US instead of the UK or Europe, and the UK is trying to attract more IPOs to its market. The price of the company shares is set by supply and demand and can fluctuate throughout the trading day.
Investors who purchase shares in the IPO can potentially profit if the company's stock price rises, but they also face the risk of losing money if the stock price falls. For the company, an IPO can provide access to new sources of capital, increased visibility, and more significant growth opportunities.
Investors who purchase shares in the IPO can potentially profit if the company's stock price rises, but they also face the risk of losing money if the stock price falls. For the company, an IPO can provide access to new sources of capital, increased visibility, and more significant growth opportunities.
What is the IPO process (in 8 steps)?
The IPO process can be complex and involves several stages. It can change a little from region to region, so research and due diligence is required depending on jurisdiction and company positioning. Here are the typical steps involved in an IPO:
- Hire an underwriter - the first step is to hire an investment bank or underwriter, who will advise the company on the offering and help prepare the registration statement.
- Prepare financial statements - the company must prepare financial statements and other disclosures.
- File registration statement - the registration statement is filed with the regulator (SEC or FCA) and includes information about the company's business, financials, risks, and management.
- Regulatory review - The regulatory authority (SEC, FCA, etc.) will review the registration statement and may provide comments or require changes before approving it.
- Roadshow - the company will conduct a roadshow, presenting its business to potential investors, usually institutional investors like mutual funds, pension funds, and hedge funds.
- Set the price - based on investor demand and market conditions, the underwriter will set the price for the shares and allocate them to investors.
- Go public - the company's shares are listed on a stock exchange and start trading publicly.
- Post-IPO - the company becomes subject to ongoing reporting and disclosure requirements, and investors can buy and sell its shares on the stock exchange.
Going public through an IPO can be lengthy and expensive, involving significant regulatory requirements and legal fees. However, it can also give the company access to new sources of capital and increased visibility.
3 Types of IPO model examples
There are three main types of IPOs:
In a fixed-price offering, the price of the shares is determined in advance and remains the same throughout the entire offering period. Investors subscribe to the shares at a fixed price, and the allotment is pro-rata.
In a book-building offering, the company and its underwriters determine a price range for the shares, and investors bid for shares within that range. The final price is then determined based on the demand for the shares, with the shares allotted to investors at the final price.
In a Dutch auction offering, investors specify the number of shares they want to buy and the price they are willing to pay. The company and its underwriters determine the highest price at which they can sell all the shares. All investors who bid at or above that price receive shares.
Each type of IPO has its advantages and disadvantages, and the choice of the offering type is usually based on market conditions and the goals of the company and its underwriters.
In a fixed-price offering, the price of the shares is determined in advance and remains the same throughout the entire offering period. Investors subscribe to the shares at a fixed price, and the allotment is pro-rata.
In a book-building offering, the company and its underwriters determine a price range for the shares, and investors bid for shares within that range. The final price is then determined based on the demand for the shares, with the shares allotted to investors at the final price.
In a Dutch auction offering, investors specify the number of shares they want to buy and the price they are willing to pay. The company and its underwriters determine the highest price at which they can sell all the shares. All investors who bid at or above that price receive shares.
Each type of IPO has its advantages and disadvantages, and the choice of the offering type is usually based on market conditions and the goals of the company and its underwriters.
Companies can benefit in several ways after an IPO, including:
Access to capital - one of the primary benefits of going public is that companies can raise significant amounts of money by selling shares of stock to the public. This capital can be used to fund growth initiatives, such as expanding operations, developing new products or services, or acquiring other companies.
Increased visibility and credibility - going public can increase a company's visibility and credibility, generating media attention and attracting new customers, partners, and employees. Additionally, being a publicly traded company can provide investors with more confidence in the company's financial and operating performance.
Enhanced liquidity - once a company goes public, its shares can be traded on a public stock exchange, providing increased liquidity compared to private investments. This can make it easier for investors to buy and sell shares and increase their value.
Employee incentives - going public can also provide employees with opportunities to participate in the company's success by offering stock options or other equity-based incentives. This can attract and retain top talent and align employee interests with the company.
There are some disadvantages too. An IPO is a costly and lengthy process, and once the company is public, it will have more significant reporting obligations, which require more time and staff. It can also affect the strategic impetus of the firm.
Access to capital - one of the primary benefits of going public is that companies can raise significant amounts of money by selling shares of stock to the public. This capital can be used to fund growth initiatives, such as expanding operations, developing new products or services, or acquiring other companies.
Increased visibility and credibility - going public can increase a company's visibility and credibility, generating media attention and attracting new customers, partners, and employees. Additionally, being a publicly traded company can provide investors with more confidence in the company's financial and operating performance.
Enhanced liquidity - once a company goes public, its shares can be traded on a public stock exchange, providing increased liquidity compared to private investments. This can make it easier for investors to buy and sell shares and increase their value.
Employee incentives - going public can also provide employees with opportunities to participate in the company's success by offering stock options or other equity-based incentives. This can attract and retain top talent and align employee interests with the company.
There are some disadvantages too. An IPO is a costly and lengthy process, and once the company is public, it will have more significant reporting obligations, which require more time and staff. It can also affect the strategic impetus of the firm.
What are the pros and cons of IPOs for a company?
Overall, going public can be a significant milestone for a company, providing access to capital, increased visibility, and other benefits that can help fuel growth and success.
Pros of investing in an IPO
IPOs can be an attractive opportunity for some investors. Here are the main benefits when evaluating an IPO investment:
✔️ Potential for high returns - IPOs can offer significant returns to early investors if the company performs well and its stock price increases.
✔️ Access to new companies - IPOs can allow investors to invest in newly public companies, which may not have been available previously.
✔️ Increased liquidity - once a company goes public, its shares can be bought and sold on a public stock exchange, providing increased liquidity compared to private investments.
✔️ Access to new companies - IPOs can allow investors to invest in newly public companies, which may not have been available previously.
✔️ Increased liquidity - once a company goes public, its shares can be bought and sold on a public stock exchange, providing increased liquidity compared to private investments.
Cons of investing in an IPO:
All investments carry some risk, and the IPO is no exception. Things to watch out for when considering an investment in an IPO include:
❌ Lack of historical data - newly public companies may have limited financial and operating history, making it difficult to evaluate their performance and prospects.
❌ Volatility - IPOs can be volatile in the short term, with prices often fluctuating significantly in the days and weeks following the IPO.
❌ Limited information - companies going public must disclose certain information in their registration statement. Still, this information may not provide a complete picture of the company's operations, financials, and risks.
❌ Volatility - IPOs can be volatile in the short term, with prices often fluctuating significantly in the days and weeks following the IPO.
❌ Limited information - companies going public must disclose certain information in their registration statement. Still, this information may not provide a complete picture of the company's operations, financials, and risks.
Whether an IPO investment is beneficial depends on the individual company, market conditions, and the investor's personal investment goals and risk tolerance.
How to evaluate IPO investment opportunities
There are multiple factors to consider when evaluating an IPO investment. However, you will only have access to financial information after the offering. Don’t feel the need to invest immediately - you can take the time to evaluate the financial reports to see if the company has long-term growth potential. Private companies are not required to disclose financial information.
Don’t get caught in the hype of an IPO. There can be a tendency to “get in” on a hot stock as soon as possible before it goes up and you “missed out”. This is emotional investing. If unsure, the best option is to wait until you are sure and can then make informed decisions.
Don’t get caught in the hype of an IPO. There can be a tendency to “get in” on a hot stock as soon as possible before it goes up and you “missed out”. This is emotional investing. If unsure, the best option is to wait until you are sure and can then make informed decisions.
QUOTE
"An IPO is like a negotiated transaction - the seller chooses when to become public - and it is unlikely to be a time that’s favourable to you.”
IPOs can be risky and may deliver inconsistent returns over a longer time horizon. The only way to profit from a stock that fails to deliver over the long term is to time the market well, which is nearly impossible for most investors.
You’ll need to ask yourself why this company is going public and the prospects for its industry/sector. You might also want to consider that valuations by third parties are often incorrect (by orders of tens of billions) and that the IPO process is very costly and time-consuming for companies.
Plus, one of the reasons an IPO is undertaken is to let early investors cash out. There could still be a lot of upside potential as the company goes from startup/private to public. But you will need to ensure this potential is there after careful deliberation.
You’ll need to ask yourself why this company is going public and the prospects for its industry/sector. You might also want to consider that valuations by third parties are often incorrect (by orders of tens of billions) and that the IPO process is very costly and time-consuming for companies.
Plus, one of the reasons an IPO is undertaken is to let early investors cash out. There could still be a lot of upside potential as the company goes from startup/private to public. But you will need to ensure this potential is there after careful deliberation.
Accessing the IPO market
While the traditional IPO allows retail investors the chance to purchase the stock for the first time, they are typically unavailable on all exchanges. Only certain brokerages will offer access to the newly issued public stock. This can represent a problem because the price might have increased drastically by the time the general investing public can access the stock.
In recent years, however, many trading platforms have started to include IPO offerings to clients. Just check the terms and conditions, as some venues might have a small selection and/or charge higher fees on specific stocks. If you are interested in trading IPOS, Trading212 offers zero commissions, fractional shares, and certain IPO listings.
It’s best not to fixate too much on the price in the days immediately after the IPO and focus more on long-term price appreciation. Bear in mind that the way a stock moves directly after its IPO listing does not indicate whether or not it will perform well over the long term. Just check out the chart below concerning Zoom and Jumia IPOs:
In recent years, however, many trading platforms have started to include IPO offerings to clients. Just check the terms and conditions, as some venues might have a small selection and/or charge higher fees on specific stocks. If you are interested in trading IPOS, Trading212 offers zero commissions, fractional shares, and certain IPO listings.
It’s best not to fixate too much on the price in the days immediately after the IPO and focus more on long-term price appreciation. Bear in mind that the way a stock moves directly after its IPO listing does not indicate whether or not it will perform well over the long term. Just check out the chart below concerning Zoom and Jumia IPOs:
Source: TradingView. Past performance doesn’t guarantee future results.In general, stocks do tend to perform well in the 12 months after an IPO, though this is dependent on the industry and the company. Another way to gain access to the IPO market is through IPO indexes.
Indexes allow you to diversify across IPOs and deliver slightly higher returns, on average, compared to low-cost index funds. However, you will have to be prepared to deal with increased levels of volatility, even with a diversified IPO index.
Indexes allow you to diversify across IPOs and deliver slightly higher returns, on average, compared to low-cost index funds. However, you will have to be prepared to deal with increased levels of volatility, even with a diversified IPO index.
According to the latest data, over three years, the results of most IPOs underperform the market. This might be surprising because, on average, IPO stocks are marketed as performing well. But this is due to a few small outliers that perform exceptionally well but might be harder to select and gain access to.
Three years after the IPO, over 60% of stocks will significantly underperform the market (by about -10%) as measured against an index. About 30% of the IPOs are very successful and tend to counteract this. The data indicates that the top 10% of IPOs earn an average market-adjusted return of over 300%.
Three years after the IPO, over 60% of stocks will significantly underperform the market (by about -10%) as measured against an index. About 30% of the IPOs are very successful and tend to counteract this. The data indicates that the top 10% of IPOs earn an average market-adjusted return of over 300%.
Source: NasdaqOne strong indicator concerning how an IPO stock will perform is sales, not profitability. Companies with less than $100 million in sales tend to underperform the market, regardless of their profitability. Unprofitable companies with high sales can do well post-IPO.
In other words, most IPOs (60%) will significantly underperform after 3 years. A small number (30%) will over-perform considerably. And increased volatility is often seen within the first year for all IPO stocks. The main items to look out for when choosing an IPO stock include the market sector, overall sales, and market penetration.
In other words, most IPOs (60%) will significantly underperform after 3 years. A small number (30%) will over-perform considerably. And increased volatility is often seen within the first year for all IPO stocks. The main items to look out for when choosing an IPO stock include the market sector, overall sales, and market penetration.
What are the most successful IPOs in history?
There have been 5,691 IPOs from 2000 to 2023, with about 200 occurring yearly. 2021 was an outlier, with over 1,000 IPOs.
While most deliver negative returns over time, some would have made an exceptional investment. Based on market capitalisation and returns for investors, the leaders include:
While most deliver negative returns over time, some would have made an exceptional investment. Based on market capitalisation and returns for investors, the leaders include:
- Saudi Aramco - the Saudi Arabian oil company that IPO’d in 2019, raising $25.6 billion in its IPO, making it the largest IPO in history. Its market value reached over $2 trillion, making it the world's most valuable publicly traded company.
- Alibaba - The Chinese e-commerce giant that went public on the New York Stock Exchange in 2014. The company raised $25 billion through the IPO. As the shares rose on the first day of trading, Alibaba’s market value soared to over $230 billion, making it one of the most successful IPOs ever.
- Visa - The credit card and payment company had its IPO in 2008 and raised $17.9 billion. Since then, its market value has grown to over $400 billion, making it one of the world's most valuable financial services companies.
- Facebook - the social media company (now known as Meta) did an IPO on May 18 2012. The IPO raised $16 billion but proved to be one of the more volatile issues for early investors. The first day was marred by various technical glitches then the shares lost over a quarter of their value by the end of May. Eventually Facebook’s market value would grow to over $1 trillion, making it one of the few companies in the world in the ‘trillion dollar club’.
- General Motors - the American automaker went public in 2010, raising $23.1 billion in its IPO. Since then, its market capitalisation has grown to over $100 billion, making it one of the largest automakers in the world.
Picking these companies is a different matter, but they were already well-known and established before the IPO. As previously stated, companies with huge sales are more likely to be sustainable in the long term, as they already have market penetration (which can be pretty expensive for other companies).
Tata Technologies, a vast India-based company, recently submitted its IPO papers to the Securities and Exchange Board of India (Sebi). The automobile producer has been around since 1945 and is a crucial player in engineering, aerospace, automotive and multiple other industries.
Tata Technologies, a vast India-based company, recently submitted its IPO papers to the Securities and Exchange Board of India (Sebi). The automobile producer has been around since 1945 and is a crucial player in engineering, aerospace, automotive and multiple other industries.
Recap
IPOs are an exit strategy for VC and early-stage funders, and the company is also transitioning to a new arena that can yield enormous profits. Investors can truthfully say they are getting in early in a “new” company. And the earlier you get in with good companies, the better the return.
But regardless of the qualities of the IPO, the old, time-tested investment principles remain the same. Pick a stock in a lucrative industry with solid fundamentals, and hold it for longer time horizons.
But regardless of the qualities of the IPO, the old, time-tested investment principles remain the same. Pick a stock in a lucrative industry with solid fundamentals, and hold it for longer time horizons.
FAQ
Q: Is an IPO a good investment?
It can be if you understand the market and have a long time horizon. You might be disappointed if you expect the price to shoot straight up after the IPO and sell for a quick profit.
The stock price can depend on factors such as the company's financial performance, competitive landscape, industry trends, economic conditions, and investor sentiment. If the company's performance meets or exceeds investors' expectations, the stock price may rise, while a disappointing performance can cause the stock price to fall.
The stock price can depend on factors such as the company's financial performance, competitive landscape, industry trends, economic conditions, and investor sentiment. If the company's performance meets or exceeds investors' expectations, the stock price may rise, while a disappointing performance can cause the stock price to fall.
Q: What are the disadvantages of the IPO for investors?
The main disadvantage is that the investor has no previous knowledge of company performance. The financials only need to be released after the company goes public. The people selling the shares have access to information the potential investor does not have. This is known as information asymmetry. Companies that have just gone public are known to have volatile share prices in the short term, which can be unnerving.
Q: Is IPO income taxable?
Yes, income earned from an IPO is generally taxable. When an investor sells shares of stock received from an IPO, any capital gains or losses are subject to tax.
Capital gains taxes are typically based on the difference between the sale price of the stock and the purchase price. If the stock is sold for a higher price than the purchase price, the investor will have a capital gain, which is subject to tax. If the stock is sold for a lower price than the purchase price, the investor will have a capital loss, which can be used to offset other capital gains and reduce taxes owed.
Additionally, if the investor receives any dividends from the stock, those dividends are also subject to tax.
Capital gains taxes are typically based on the difference between the sale price of the stock and the purchase price. If the stock is sold for a higher price than the purchase price, the investor will have a capital gain, which is subject to tax. If the stock is sold for a lower price than the purchase price, the investor will have a capital loss, which can be used to offset other capital gains and reduce taxes owed.
Additionally, if the investor receives any dividends from the stock, those dividends are also subject to tax.
Q: Do most stocks go up or down after an IPO?
IPO stock performance can vary significantly based on the company's earnings, market conditions, and other factors.
In general, it's not uncommon for newly public companies to experience volatility in the short term following their IPO, with prices often fluctuating significantly in the days and weeks after the offering. This is because the demand for the shares may exceed the supply, resulting in an initial price surge, but this surge can be short-lived if investors believe the stock is overvalued.
In general, it's not uncommon for newly public companies to experience volatility in the short term following their IPO, with prices often fluctuating significantly in the days and weeks after the offering. This is because the demand for the shares may exceed the supply, resulting in an initial price surge, but this surge can be short-lived if investors believe the stock is overvalued.
Q: How long does an IPO last?
The duration of an IPO can vary, but the typical timeline for an IPO process is between 4-6 months, although it can take longer in some cases.
The IPO process usually involves several stages, including selecting underwriters, preparing and filing registration statements with the Securities and Exchange Commission (SEC), and marketing and pricing of the shares. The duration of each stage can vary depending on factors such as the complexity of the offering, the size of the company, and the regulatory requirements.
Once the IPO is priced, the offering typically lasts for a day or two, when the shares are sold to investors. After the IPO, the shares begin trading on a public stock exchange, and investors can buy and sell them as they would with any other publicly traded stock.
The IPO process usually involves several stages, including selecting underwriters, preparing and filing registration statements with the Securities and Exchange Commission (SEC), and marketing and pricing of the shares. The duration of each stage can vary depending on factors such as the complexity of the offering, the size of the company, and the regulatory requirements.
Once the IPO is priced, the offering typically lasts for a day or two, when the shares are sold to investors. After the IPO, the shares begin trading on a public stock exchange, and investors can buy and sell them as they would with any other publicly traded stock.
Q: Should you buy a stock right after an IPO?
When to buy IPO stocks depends on your investment goals and risk tolerance levels. It also helps to consider time horizons. Investors with longer time horizons can take on increased risk. Investors with shorter time horizons might better wait until the stock price stabilises.
IPOs can be priced too high and are often over-valued. There is a possibility that the price could simply sink back within a normal range. Investors need to take this into account.
IPOs can be priced too high and are often over-valued. There is a possibility that the price could simply sink back within a normal range. Investors need to take this into account.
Q: Where do the majority of IPOs take place?
As of 2021, the NASDAQ and NYSE completed the most IPOs. Shanghai, Hong Kong, and Shenzhen exchanges are not far behind, followed by the LSE. In other words, IPO launches are mainly held in the US and China, followed by England. The US hosts more than seven times more IPOs than the UK.
