The Basics of an Initial Public Offer (IPO)

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IPO Definition

An initial public offering (IPO) is when a private company first offers stock to the public as it becomes a publicly traded company. These companies undergo IPOs to grow their business, and they need to raise capital to do so. IPOs are also a cost-efficient way to finance growth objectives. When companies sell shares to the public, they increase their equity. This improves the company’s debt to equity ratio, which will improve their ability to borrow funds if needed. IPOs can also improve and expand the company’s public image.

Process

When a private company decides to list on the stock exchange, they assign an investment bank to act as the underwriter. The underwriter evaluates the value of the shares and sets an offer price. They need to establish a price that is low enough to attract interest but high enough to raise enough capital for the company. Investment banks will use their distributed network to sell these IPOs.  These may include fund managers, insurance companies and other financial institutions. When the IPO is underwritten, the underwriter will be obligated to buy the remaining unsold shares.

Book Building

This is a method an underwriter may use to assist them to decide what to price an IPO. They do this by building a book and from using their network to collect bids from different institutional investors on the price and the number of shares they want to take on. The underwriter will use the feedback from this group of small investors to set the offer price. Prior to book building, IPO’s were underpriced or overpriced. This process has therefore enable underwriters to set more appropriate prices.

 Disadvantages of an IPO

  • Traditional Fundamental and Technical analysis would be challenging as there would be a lack of stock trading history
  • Investing in IPOs can be risky due to the uncertainty surrounding them from the lack of available information
  • IPOs may involve smaller but fast-growing companies which have been operating for a short period or only sell few products
  • It is expensive for the company as the average cost for a company listing is $3.7 million for the IPO, on top of the 5-7% underwriter’s fees. There are also ongoing cost each year just to be a public company
  • A lack of trading history can make the companies more prone to falling in a down market
  • There is a risk of the stock being overpriced or undervalued when the initial price is set.

Advantages of an IPO

  • Good opportunity to invest in a company when the market is overvalued and there are no good existing companies to buy
  • IPOs have historically done well on the first day. If you participated in all the IPOs in 2016 on the ASX, you would have yielded 17 percent on the first day. Over the last 10 years the average first day rise for all newly listed shares on the ASX was 14.9 per cent.
  • If the investor believes the company has long term potential, then the investor can purchase these shares at a lower level if they get in early on. Some examples of successful IPOs are:
  1. CBA privatised in 1991 at $5.37 a share, it now worth $80.22 as of 2nd Jan 2018
  2. Cochlear listed in 1995 at $2.90 a share, it now worth $170.25 as of 2nd Jan 2018
  3. CSL listed in 1994 at $2.30 a share, it is now worth $141.30 as of 2nd Jan 2018
  • As there are no earnings record for the stock, the shares may be offered at a discount to encourage investors to purchase
  • Potential for very good returns when the market is steady and rising
  • Initial Public Offers can provide a lucrative opportunity to invest in a stock that the general market may not be aware of. IPOs are only available to those who know about it so those investors who get in first may be able to get in on the ground level.

Lauren Hua is a private client adviser at Fairmont Equities.

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