What is an IPO and Should You Invest?
Over the past few months we've seen 3 companies go public; Beyond Meat, Lyft, and Uber. Some companies’ stock did well, while others took a hit. Because of the great economy we are experiencing right now, many have seen this period of time to be a good time to take your company public and these 3 companies did just that. In today's post, we'll look at what an IPO is and what are some of the pros and cons of investing in them.
What is an IPO?
IPO stands for Initial Public Offering. According to Investopedia, "An IPO is the very first sale of stock issued by a company to the public. Prior to an IPO, the company is considered private, with a relatively small number of shareholders made up primarily of early investors (such as the founders, their families and friends) and professional investors (such as venture capitalists or angel investors)." An IPO is usually a big deal and usually, only private companies with strong fundamentals and proven profitability potential could qualify for an IPO.
Not everyone has the ability to take advantage of IPO’s. There are certain requirements and things regulators look for if a company wants to apply and go through that process. Once a company has been approved, they usually go on what’s called a roadshow where they are telling big investors why they should invest in their company. It is essentially a big marketing campaign. Then it is usually announced in the news that the company is getting ready to go public on a certain date.
In the example of the 3 companies above, none of them have produced a profit yet but were still able to go public. So why would a company decide to go public?
There are a few reasons, but two of the main reasons are that going public raises a great deal of money for the company which allows it to grow and expand. As a private company you can borrow money and take out loans, but it is hard to generate a large sum of money very quickly like you can from doing an IPO. For example, Beyond Meat just raised $240 Million, Lyft raised $2.34 Billion, and Uber raised $8.1 Billion from their IPO's. Another reason for an IPO is that it can be an exit strategy for the company founders and early investors to profit from their early risk-taking in a new venture. Therefore, in an IPO, many of the shares sold to the public were previously owned by those founders and investors.
Now we will look at the pro's and cons of an IPO from an investor's standpoint:
Flipping the Stock
One option you have is to buy the stock at its price when it goes public and if the stock soars in the first couple of days you can sell it for a profit. For example, Beyond Meat's initial stock price was $25 and the high was $85.45. If you timed it perfectly and sold at the high, the return on your money would have been 241.80%!! It is rare that you find investments that can give you that rate of return in such a short time span. It was also one of the best performing IPO’s in nearly two decades.
Long Term Growth Potential
As an investor, one of my strategies is that I am a long term investor and use a buy and hold strategy. Because of that, I'm not as concerned if the price goes down initially or is volatile in the short term because I believe that in the long run, stocks will generally increase in value. If you apply this same strategy to investing in an IPO, you and your family can reap the benefits for generations to come. For example, Walmart went public in 1970 and its initial stock price was $16.50/share. As of today, their stock is currently trading at around $100. If you had purchased 100 shares of Wal-Mart Stores on Oct. 1, 1970, at its Initial Public Offering (IPO) price per share, after stock splits, your investment would be worth over $12 million. Moreover, you would have received an annual dividend of over $400,000. That is the long-term growth potential that can come from investing in an IPO and then realizing the benefits years down the line.
Stock Price Volatility
While the stock price has the ability to shoot up, many times the price will fluctuate and drop below the initial IPO price. According to a report by Renaissance Capital, out of the 170 IPOs that priced in 2015, 57% finished the year below their offer price. The most recent examples are the IPO's of Lyft and Uber. Lyft's initial price was $72 per share which was at the lofty end of the spectrum and as of 5/15/19 is currently trading around $54 per share. Uber had it's IPO 6 weeks after and decided to take a different approach and price itself towards the lower end and had its initial price set at $45 per share and as of 5/15/19 is currently trading around $41 per share. Uber was one of the most hyped IPO's in history and many people were excited to see it go public. Unfortunately, it did not live up to expectations and dropped nearly 11% after the first day of trading to a price of $37.10 making it the biggest first-day dollar loss in US IPO history.
However just because a stock doesn't perform well in the beginning, doesn't mean it will always stay that way. The CEO of Uber Dara Khosrowshahi sent out an email to employees at Uber to reassure them after their rough start. In part of the email, he said "Remember that the Facebook and Amazon post-IPO trading was incredibly difficult for these companies and look at how they have delivered since. Our road will be the same." That is one of the benefits of being a long-term investor; you have time on your side and because of that, the stock has time to bounce back.
Warren Buffet, who is one of the worlds greatest investors hasn’t bought an IPO in Berkshire Hathaway's 54 years of business. He says that "IPOs tend to be driven largely by hype, and there's tremendous incentive to sell the shares and generate high commissions. The idea of saying the best place in the world I could put my money is something where all the selling incentives are there, commissions are higher, the animal spirits are rising, that that's going to better than one thousand other things I could buy where there is no similar enthusiasm ... just doesn't make any sense." This is great wisdom and his words rang true in the most recent case if you look at Uber.
The bottom line is that investing in an IPO has both positives and negatives to it. You just need to be careful when deciding if you want to invest in an IPO. If you decide you want to, make sure you are doing it for the right reasons and you're not t getting sucked into the hype of what everyone else is talking about. One of the biggest downfalls investors face is making emotional decisions. As we talked about last week, taking the emotion out of investing will help you have more success in the long run. Getting in at the beginning of a company can be beneficial and many companies stocks have gone on to do well which has led to investors celebrating it but make sure you do your research and invest for the right reasons!
What are your thoughts on these 3 recent IPO's and do you think Uber's stock will turn around? Let me know in the comment section below!