IPOs can be exciting investment opportunities, offering the chance to invest in companies as they first become publicly traded. However, IPO investing also carries significant risks that many investors overlook. In this guide, we will explain how IPOs work and how to approach them wisely.
What is an IPO?
An Initial Public Offering (IPO) is when a private company sells shares to the public for the first time. Before an IPO, only founders, employees, and private investors own shares. After the IPO, anyone can buy and sell the stock on public exchanges.
Why companies go public: Companies use IPOs to raise capital for expansion, allow early investors and employees to cash out, increase visibility and credibility, and use stock for acquisitions and employee compensation.
How the IPO Process Works
- Company prepares: Hires investment banks, auditors, and lawyers
- SEC filing: Files S-1 registration with detailed business information
- Roadshow: Management presents to institutional investors
- Pricing: Investment banks set the IPO price based on demand
- First trading day: Stock begins trading on the exchange
- Lock-up period: Insiders cannot sell for typically 90-180 days
Ways to Invest in IPOs
IPO Allocation
Getting shares at the IPO price before trading begins. This is difficult for individual investors since most allocations go to institutional investors and wealthy clients.
First-Day Trading
Buying shares when trading opens. Prices often jump significantly from the IPO price, and volatility can be extreme.
Wait and Watch
Many experienced investors wait 3-6 months after an IPO before considering an investment. This allows:
- Initial volatility to settle
- At least one earnings report to be released
- Lock-up expiration and insider selling to occur
- Better understanding of the company as a public entity
IPO Price Dynamics
- IPO price: $25 (set by investment banks)
- Opening trade: $35 (market demand pushes price up)
- First day close: $40 (retail FOMO buying)
- Six months later: $22 (reality sets in)
This pattern is common. Many IPOs trade below their first-day price within a year.
Evaluating an IPO
When considering an IPO investment, analyze these factors:
Business Fundamentals
- Revenue growth: Is the company growing quickly?
- Profitability: Is it profitable or burning cash?
- Market opportunity: How large is the addressable market?
- Competitive position: What advantages does it have?
Valuation
- Compare price-to-sales or price-to-earnings to similar public companies
- Consider the growth rate relative to valuation
- Be wary of extreme valuations justified by distant future potential
Use of Proceeds
- Is the company raising money for growth or to pay off debt?
- Are insiders selling large portions of their holdings?
- Heavy insider selling at IPO is often a warning sign
Risks of IPO Investing
Limited Information
New public companies have shorter track records as public entities. You cannot see how management performs under public scrutiny.
Volatility
IPO stocks are often extremely volatile, especially in the first months of trading.
Lock-up Expiration
When insiders can finally sell (usually 90-180 days after IPO), additional supply can push prices down.
Hype vs Reality
IPOs generate excitement that can inflate prices beyond reasonable valuations. The hype eventually fades.
Asymmetric Information
Insiders and institutional investors know far more about the company than retail investors.
Sobering statistic: Studies show that IPO stocks, on average, underperform the broader market over the three years following their debut. The most hyped IPOs often perform worst.
IPO Investing Strategies
Be Patient
Wait for the initial excitement to fade. Most IPOs can be bought cheaper months after their debut.
Do Your Research
Read the S-1 filing carefully. Understand the business model, risks, and financials.
Start Small
If you do invest in an IPO, keep the position size small relative to your portfolio.
Focus on Quality
The best IPO investments are often companies with real revenues, clear paths to profitability, and reasonable valuations.
Track Your IPO Investments
Pro Trader Dashboard helps you monitor your IPO investments, track performance, and manage your portfolio positions effectively.
Summary
IPO investing can offer exciting opportunities, but it comes with significant risks that many investors underestimate. The best approach for most investors is to wait until the initial hype fades, gather more information, and then evaluate the company on its fundamentals rather than its buzz. If you do invest in IPOs, keep position sizes small and be prepared for volatility.
Want to learn more about stock investing? Check out our guides on growth stocks and speculative stocks.