Whenever a pretty young thing comes on the scene, it’s bound to turn heads. On Wall Street, those PYTs are called IPOs.
What’s an IPO again?
An initial public offering is when a private company sells shares to the public on the stock market for the first time. It’s one way companies can raise money to expand the business.
Before launching an IPO, a company works with investment banks (the underwriters) to determine its value based on historic and projected revenue, profits, costs and other factors. Then they determine how many shares to sell—and how many the company’s board members should keep.
Underwriters also estimate a fair value for those initial shares, but public demand plays a big role. High demand drives high prices; low demand means low prices—and possibly a delay in going public.
How do regular investors get in on a hot IPO?
Brazenly. Popular IPOs are riskier than standard stocks—and, of course, don’t provide broad diversification like investing in funds—because they’re often issued by young companies with green management. Potential investors must be able to handle the risks.
If that’s cool, then you can invest once the company goes public through your broker, like with any other stock. But don’t expect to nab an IPO at its opening price, which is generally reserved for the company’s management, employees, friends and families, as well as for bulk buyers such as investment banks and hedge funds.
Should I invest in a company that IPOs?
Your call. Like with any other investment, you have to decide whether it is worth the price and fits your investing strategy. The trouble with IPOs is that you’re not going to find much historical data and research. Plus, those early trading days are bound to endure some big price swings.
And while there are IPO success stories, a recent UBS analysis found that most investments in recently IPO’ed companies lose investors money after five years.
What’s the bottom line?
It’s probably best to give a hot IPO time to cool off. While you won’t get in on the ground floor, you’ll likely miss the early peak prices driven mainly by excited chatter rather than performance. Once the frenzy subsides, you can see where the price settles and make an informed decision about whether it makes sense to add to your portfolio.
It’s worth noting that chasing any hot stock or trying to time a particular stock’s rise or fall is a risky proposition (and a potentially costly one). Advisors generally agree that the better approach is to invest for the long term with a diversified portfolio of stocks and bonds, and to resist getting caught up in the hype over specific stocks.
Investing involves risk including loss of principal. This information is presented for educational purposes only and is not a recommendation to buy or sell a specific security or engage in a particular strategy.
By Stacy Rapacon
Stacy is a former reporter for Kiplinger’s Personal Finance magazine whose work has also appeared on CNBC.com, Bloomberg, Yahoo and other publications.
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