Facebook’s recent IPO and resulting stock price flop have been all the talk in both financial and general news media as of late. Billions have been made and lost on that single stock alone.
But what exactly is an IPO? And does it really matter to the average investor?
What is an IPO?
IPO stands for “Initial Public Offering”.
When a private company wants to sell a share of the company to the public in order to raise capital to continue expanding operations it is done through an initial public offering. It is called this because up to this point the private company hasn’t sold a share of the company publicly on the stock market.
In short, an IPO is when a privately held company owned by a few individuals or handful of investors, sells a chunk of the company on the publicly traded stock markets.
Why Do Private Companies Go Public?
Why would a privately held, successful, profitable company want to sell off a share of the company to public investors? Why not keep as much ownership in the company as possible?
Founders, Investors, and Venture Capitalists Cashing Out
Virtually every startup company takes on additional investors as it grows.
These investors and venture capital firms provide millions of dollars of capital that allow the company to continue growing and taking market share. They are rewarded with an ownership stake for their investment with the hope of selling that stake at a much higher price in the future. When companies go public the founders (who hold a lot of ownership), investors, and venture capital firms can cash out a chunk of their ownership to investors on the stock market for massive profits.
Investing in Growth
A second reason companies go public is to get even more capital to continue growing. Perhaps they can’t find additional investors or they simply need more money than a line of venture capital firms can provide. Instead, they go to the public stock markets and sell a stake of ownership to raise the capital needed to expand or continue operations.
Should I Care About Initial Public Offerings?
Should the average investor pay any attention to IPOs? Or is it best to let them pass on by?
For Your Profit, No
It is very easy to get emotionally invested in a hyped up initial public offering.
Facebook had a “road show” where they went to major investors to pitch them on investing in the company. While this information wasn’t handed out publicly (one reason they are being sued, since critical information that downgraded the stock’s value was shared to a handful of private investors), the media still covered it like it was a big deal. When you turn on the evening news and see a report about a company getting ready to go public you automatically find yourself wondering if you should invest.
And your wonder should stop there.
Generally speaking IPOs are a terrible investment for individual investors. Not because shares of companies do not go up — sometimes massively — on the day they go public, because that does happen from time to time.
Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.
– Warren Buffett
No, you should avoid IPOs because they are individually traded companies and 99% of investors are not qualified to maintain a diverse portfolio of individual stocks.
The easiest investment portfolio consists of three mutual funds or ETFs: one for the total stock market (US), one for the total international stock market, and one for the total bond market. You simply set it, automate your investments, and forget it.
However, many wise financial advisers know that despite their best warnings, some individuals will still want to invest in individual stocks. If you do so, only dedicate 5% of your portfolio. You can afford to lose 5%, not 50%.
For Your Portfolio, Yes
As bad as investing in IPOs and individual stocks can be for your portfolio, you should still care about them in one aspect. If you buy additional shares on your own you may be drastically increasing your exposure to the stock because the mutual funds and pension plans you participate in may already be investing in the IPO.
How can you know if your funds are investing in these new companies?
The easiest way is to go to the fund’s website and read the associated prospectus and reports. Sometimes finding what is called a “Composition Report” can be a little tricky. Once you find it the report will usually list out not only the top 10 holdings of the fund, but every holding and what percentage of the fund each holding amounts to.
Final Thoughts on IPOs
IPOs are best for the underwriting companies who make millions by underwriting the initial public offering of the stock.
They are also usually very good for founders, early stage investors, and venture capital firms that own a share of the company that is going public.
Coming in dead last is the individual investor that buys into the company at a price dictated by the underwriting firm in hopes of the shares either skyrocketing immediately or over time.
Don’t buy into the marketing hype around a stock and look at fundamentals: when Facebook went public it was trading at a P/E ratio of around 100. Most stocks are in the 15 to 25 range. It was simple to see this was a horrible investment, buy many individual investors bought the hype and let their emotions dictate when they would buy.