The basics of IPO investing

December 3, 2013, 3:36 pm David Koch Yahoo7

Don't get swept up in the hype: look out for these five things before you jump in.

Confidence is coming back to sharemarkets and the spruikers are out in force. A whole raft of private companies are getting set to list on markets over the next few months, including Twitter, the Nine Network and Dick Smith to name a few.

But before you get swept up in shiny prospectuses, analyst estimates and press coverage, let's take a look at the basics of investing in an Initial Public Offering, or IPO. Here are the top five things to look out for before jumping in.

Overly optimistic forecasts

One important thing to watch out for is any undue optimism in expected earnings. The company’s prospectus will provide past results and forecasts of coming years, and warning bells should be ringing if these aren’t broadly in line with each other.

While it’s impossible to guess how successful a company might be, don’t take predicted forecasts as definite. It’s important to remember that share prices can fall as well as rise once listed, and that not all companies will pay dividends to shareholders.

New companies may invest all profits back into the company, often meaning no cash return for a number of years.

Under-analysed performance

Because they’re newly listed companies, IPOs haven’t had the same industry and analyst scrutiny as listed companies. It can be difficult to find a track record and extensive research, making it crucial to do your own research.

Learn as much as you can about the company, as well as its competitors.

The prospectus will provide important information, so scrutinise it carefully. But remember it’s all still written by the company, not an independent third party.

Look at growth prospects over the coming three to five years, the predictability of earnings streams and anticipated strength of the balance sheet after the float.

MoneySmart provides a checklist of what to look for when evaluating an IPO, and includes an overview of the company and the offer, as well as costs, business plans, use of funds, performance, risk, directors and managers.

Consider what you’re getting for your money, how much will it cost and if it will cost you more in the future.

Also, step away from the individual IPO and weigh up whether it’s likely to suit your overall investment goals. Often the bigger picture is overlooked because of the focus on this one opportunity.

Raising for the wrong reasons

An IPO is essentially just selling stock. The previous owners are trying to raise capital for expanding the business, cashing out their interest or for a range of other reasons. This usually means a premium price for investors.

It’s important to question what the money is being used for and why the company can’t grow some other way. Consider whether the promoters are participating to buy or sell shares as well.

If the money raised is going to be used for expansion, will it improve the company’s position on growth and revenue? Can the industry absorb additional supply if all players take the same path?

An unusual opportunity

Underwriters offer the stock to major brokers who offer it first to big retail and institutional customers. By the time most investors get a chance to buy shares, it could be substantially above the initially offered price.

If a broker is strongly pitching shares, think about why there’s a high number available. Great value IPOs are usually very hard for retail investors to get shares in as investment banks and high rollers usually snap them up.

And always be cautious using smaller brokerages – a bigger, quality brokerage will generally have higher underwriting standards.

Too much excitement

It’s easy to get carried away with the hype an IPO brings, so remember that underwriters are salesmen. IPOs only happen once for each company, so are presented as “once in a lifetime” opportunities.

If the stock falls fifty percent, will you be able to continue holding without any emotional response? Look at an IPO sceptically and you’re more likely to come away with a good investment.

Stock Quotes

e.g. BHP, CBA