Lesson 14: IPO Trading

An investment in an IPO has the potential to deliver attractive returns, but sometimes investors lose a lot of money. Prior to investing, it is important to understand how the process of trading these securities differs from ordinary stock trading, along with the additional risks and rules associated with IPO investments. 

How to use this guide? 

• Check the upcoming IPOs. Saudi Arabia’s stock exchange reported 70 applications in pending   
• Get in on the ground floor. Discover how to trade a company’s shares with our guide to initial public offerings (IPOs) 
• Choose an IPO to trade. Trade the underlying company shares with a leveraged trading account at CAPEX.com. 
• Build your IPO strategy. Make sure you know when you plan to take profits and cut losses. 

What is an IPO? 

There are thousands of companies that trade on the New York Stock Exchange (NYSE), Nasdaq, or Tadawul. These companies range from the leviathan Apple or Saudi Aramco to the smaller, more inconsequential companies, with market capitalizations of less than the price of a car. 

Every one of those companies had to start somewhere. They each sprang to trading life with initial public offerings (IPOs), turning from private companies to public ones, attracting investors, and raising capital. 

An initial public offering (IPO) is when a private company becomes public by selling its shares on a stock exchange. 

Private companies work with investment banks to bring their shares to the public, which requires tremendous amounts of due diligence, marketing, and regulatory requirements. 

Purchasing shares in an IPO is difficult as the first offering is usually reserved for large investors, such as hedge funds and banks. 

Common investors can purchase shares of a newly IPO-ed company quickly after the IPO. 

When an IPO has happened, you can start trading in shares, as you would any other shares on the stock market. Open a CAPEX account to: 

• Go long or short on share prices by leveraged trading 
• Get instant access to 0 commission, unleveraged fractional shares 

Remember, if you’re trading, you can profit from upward or downward share price movements. 

How Does an IPO Work? 

Going public is a challenging, time-consuming process that’s difficult for most companies to navigate alone. A private company planning an IPO needs not only to prepare itself for an exponential increase in public scrutiny but also so must file a ton of paperwork and financial disclosures to meet the requirements of the Securities and Exchange Commission (SEC), which oversees public companies. 

That’s why a private company that plans to go public hires an underwriter, usually an investment bank, to consult on the IPO and help it set an initial price for the offering. Underwriters help management prepare for an IPO, creating key documents for investors and scheduling meetings with potential investors, called roadshows. 

The underwriter puts together a syndicate of investment banking firms to ensure widespread distribution of the new IPO shares. Each investment banking firm in the syndicate will be responsible for distributing a portion of the shares. 

Once the company and its advisors have set an initial price for the IPO, the underwriter issues shares to investors, and the company’s stock begins trading on a public stock exchange, like the New York Stock Exchange (NYSE) or the Nasdaq. 

Why Do an IPO? 

An IPO may be the first time the public can buy shares in a company, but it’s important to understand that one of the purposes of an initial public offering is to let early investors in the company cash out their investments. 

Think of an IPO as the end of one stage in a company’s life cycle and the beginning of another—many of the original investors want to sell their stakes in a new venture or a start-up. Alternatively, investors in more established private companies that are going public also may want the opportunity to sell some or all their shares. 

There are other reasons for a company to pursue an IPO, such as raising capital or boosting a company’s public profile: 

• Companies can raise additional capital by selling shares to the public. The proceeds may be used to expand the business, fund research and development, or pay off debt. 
• Other avenues for raising capital, via venture capitalists, private investors, or bank loans, may be too expensive. 
• Going public in an IPO can provide companies with a huge amount of publicity. 
• Companies may want the standing and gravitas that often come with being a public company, which may also help them secure better terms from lenders. 

While going public might make it easier or cheaper for a company to raise capital, it complicates plenty of other matters. There are disclosure requirements, such as filing quarterly and annual financial reports. They must answer to shareholders, and there are reporting requirements for things like stock trading by senior executives or other moves, like selling assets or considering acquisitions. 

Pros of IPOs 

A successful IPO can raise massive amounts of capital, as becoming listed on a stock exchange can help to increase the exposure and public image of a company. In turn, the firm’s sales and profit can increase. IPOs are also beneficial to traders because it’s easier to buy publicly traded shares than those that only trade privately. 

Cons of IPOs 

Public companies are subjected to the rules and regulations of a governing body. One of the rules is that it is required to publicly disclose financials, such as accounting information, tax, and profits. IPOs also carry significant costs and could require the company to raise additional funding if its shares perform poorly. 

Upcoming IPOs   

IPO activity hit record highs in 2021, thanks to the strong global stock markets.  

Global IPO activity broke new records in 2021, with every region of the world recording significant increases in the number of businesses coming to market. The proceeds of these IPOs totaled more than US$600 billion—a new high. 

With interest rates at rock bottom, investors poured money into capital markets—creating a supportive environment for IPOs. In addition, some of the impacts of the pandemic proved helpful to the IPO market. The way we live our lives is continuing to change rapidly, accelerating trends in how we work, shop, and play, and the environmental imperative is more front of mind than ever. In industries such as financial services, life sciences, and, particularly, technology, this is creating huge opportunities for innovative new businesses. 

These trends—the energy transition and growing digitalization across all industries—will continue to motivate corporate activity, including IPOs. The IPO outlook for 2022 is quite different, with expected initial offerings being postponed and even canceled thanks to the many issues facing the market. As worries about inflation began to dominate headlines, and there were signs that central banks were planning to raise rates, equity markets began to cool at the end of 2021. Russia’s invasion of Ukraine and the continuing conflict there have increased volatility considerably—never good for IPOs. It is still unclear, however, how long the disruptions will last. Already the global economy was struggling with pandemic-related supply chain issues—these could be exacerbated by the impact of the situation in Ukraine, including sanctions on Russia. 

Here are some of the more prominent upcoming IPOs: 

Key IPO Terms 

Like everything in the world of investing and financial markets, initial public offerings have their own special jargon. You’ll want to understand these key IPO terms: 

• Common stock. Units of ownership in a public company typically entitle holders to vote on company matters and receive company dividends. When going public, a company offers shares of common stock for sale. 
• Issue price. The price at which shares of common stock will be sold to investors before an IPO company begins trading on public exchanges. Commonly referred to as the offering price. 
• Lot size. The smallest number of shares you can bid for in an IPO. If you want to bid for more shares, you must bid in multiples of the lot size. 
• Preliminary prospectus. A document created by the IPO company that discloses information about its business, strategy, historical financial statements, recent financial results, and management. It has red lettering down the left side of the front cover and is sometimes called the “red herring.” 
• Price band. The price range in which investors can bid for IPO shares, set by the company and the underwriter. It’s different for each category of investor. For example, qualified institutional buyers might have a different price band than retail investors like you. 
• Underwriter. The investment bank manages the offering for the issuing company. The underwriter determines the issue price, publicizes the IPO, and assigns shares to investors. 

How to Evaluate Buying an IPO Stock 

If you've decided on buying IPO stock, be sure to consider the strengths of the business itself. Ask yourself a few key questions: 

• If this business does not grow at a high enough rate to justify its price, what is the reason? What are the probabilities of those failures occurring? 
• What are the competitive moats that protect the business? Are there patents, trademarks, key executives, or some other unique factor protecting it? 
• What is stopping some other firm from coming in and destroying the attractive economics? 

Also, consider your personal level of comfort with the business and how it is run: 

• Would you be comfortable owning this business if the stock market were to close for the next five, 10, or 25 years? In other words, is this business model and the company's financial foundation sustainable? Or is obsolescence because of technological advancement or lack of sufficient capital a possibility? 
• If the stock falls by 50% due to short-term problems in the business, will you be able to continue holding your shares without any emotional response? 

Do your due diligence on the company and its prospects before plunking capital down. It may be difficult to do, as the company hasn't made a good deal of financial information public to that point, but it's crucial to your success. 

Metrics for judging a successful IPO process 

The following metrics are used for judging the performance of an IPO: 

Market Capitalization: The IPO is successful if the company’s market capitalization is equal to or greater than the market capitalization of industry competitors within 30 days of the initial public offering. Otherwise, the performance of the IPO is in question. 

Market Capitalization = Stock Price x Total Number of Company’s Outstanding Shares 

Market Pricing: The IPO is successful if the difference between the offering price and the market capitalization of the issuing company 30 days after the IPO is less than 20%. Otherwise, the performance of the IPO is in question. 

Should You Invest in the upcoming IPOs? 

As with any type of investing, putting your money into an IPO carries risks—and there are more risks with IPOs than buying shares of established public companies. That’s because there are less data available for private companies, so investors are making decisions with more unknown variables. 

Despite all the stories you’ve read about people making bundles of money on IPOs, there are many more that go the other way. In fact, more than 60% of IPOs between 1975 and 2011 saw negative absolute returns after five years. 

Just because a company goes public, doesn’t necessarily mean it’s a good long-term investment. 

Conversely, a company might be a worthwhile investment but not at an inflated IPO price. You could buy the best business in the world, but if you overpay for it by 10 times, it’s going to be hard to get your capital back out of it. 

Buying IPOs, for most buyers, isn’t investing—it’s pure stock speculation, as many of the shares allocated in the IPO are flipped on the first day.  

If you really like the stock and plan to hold it as a long-term investment, it is recommended to wait a few weeks or months until the frenzy has disappeared, and the price has come down. 

The Benefits of Buying IPO Stock 

Buying IPO stock can be appealing. A block of common stock bought during an initial public offering has the potential to deliver huge capital gains decades down the line. Even just the annual dividend income of an extraordinarily successful company can exceed the original investment amount, given a few decades' time. 

Your investment provides capital to the economy, enabling companies that provide real goods and services to grow and expand. Learning how to buy IPO stock can lead to extremely attractive results when conditions are right. 

The Downsides of IPO Investing 

The biggest downside for IPO investors is dealing with volatile price fluctuations. It can be hard to stay invested when the value of your shares plummets. 

Many stockholders don't stay calm when prices tumble. Rather than valuing the business and buying accordingly, they look to the market to inform them. However, in doing so, they fail to understand the difference between intrinsic value and price. 

Instead, consider whether look-through earnings and dividend growth are growing and poised to stay that way. 

The Bottom Line 

The late and legendary Benjamin Graham, who was Warren Buffett's investing mentor, decried IPOs as being for neither the faint of heart nor the inexperienced. They're for seasoned investors; the kind who invest for the long haul, aren't swayed by fawning news stories and care more about a stock's fundamentals than its public image. 

For the common stock investor, purchasing directly into an IPO is a complicated process, but soon after an IPO, a company's shares are released for the public to buy and sell. If you believe in a company after your research, it may be beneficial to get in on a growing company when the shares are new. 

FAQs 

How long is the IPO process? 

The length of the IPO process can vary, depending on how well it’s being managed and coordinated. The first step is a financial audit of the company, which can be the longest part of the process – especially if the company’s books are not in order. 

The business then has to prepare a registration statement to file for the IPO. The next step is to allow the stock exchange to review the application. This can happen quickly if it has no concerns. A well-managed IPO could take up to 12 months, but it could be longer. 

How do I find new IPO stocks? 

To find new IPO stocks, you can sign up for our IPO mailing list. You’ll receive updates on upcoming IPOs and any changes to expected listings. 

How much does an IPO cost? 

Any company wanting to list on a stock exchange has to carry the cost of an IPO – no costs are carried by the individual trader or investor before they start online trading. Charges differ from leveraged trading. 

The cost of an IPO for a company will depend on the registration requirements of the stock exchange where it is being listed. In addition, there will generally be underwriting fees and offering costs, as well as legal and accounting fees. Larger companies could face additional costs when preparing to list. 

How is the IPO price calculated? 

The IPO price is calculated by an investment bank. First, the company decides how many of its shares it wants to sell to the public. Then, the nominated investment bank does a thorough valuation of the business. Once that’s done, an initial share price is released, and the public can start trading shares when the listing happens.