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A popular private company going public often sparks excitement among traders and investors. For many people, it is an opportunity to get in on a company that is dominating the airwaves.
However, looking beyond the headlines often reveals that the same company struggles to gain significant market share or become consistently profitable. Many companies that have benefitted from the IPO hype end up falling flat after a few months and years, to the loss of early believers.
Consequently, investors and traders interested in an IPO should ask a fundamental question: Is this company worth buying, or is its popularity on social media and in the news media a product of mere hype?
Even when the company seems to have solid fundamentals, investors and traders must also look at the valuation and ask another fundamental question: Is the company fairly valued, overvalued, or undervalued?
In this article, we consider the important questions you should ask when considering investing in an IPO.
Examining the company’s fundamentals
Learning how to invest in an IPO begins with getting informed on how to read a prospectus.
A prospectus is a document that a company prepares when it is getting ready for an IPO. It provides details about the company’s business model, financial statements, management team, investment risk, and plans for the money they want to raise.
When evaluating a prospectus, the company’s revenue is a good place to start. Some relevant questions to ask include:
- Is the company consistently growing revenue?
- Is recent revenue growth sustainable or is it the result of a temporary demand surge?
Is the company positioned to increase its market share or are competitors poised to dominate the market?
Profitability matters too.
Many companies in growth industries (especially technology) can report strong revenue while making losses due to high operating expenses. When evaluating the company’s financial statements, consider the following:
- Is the company profitable?
- Is the profit due mainly to cost efficiency or growing revenue?
- If the company is not profitable, what does the path to profitability look like?
You should also check the company’s balance sheet, especially its cash position and debt levels. Too little cash may mean future capital raising, which will dilute existing shareholders. Similarly, too much debt may be risky in terms of future growth.
Valuing the company against its peers
A company with strong revenue, profitability, and balance sheets can still be a bad IPO investment if the IPO price is too high.
You can check if the company is fairly valued by comparing it with its industry peers using multipliers like the P/E ratio, P/S ratio, enterprise value to revenue ratio, among others. The best multiplier depends on the industry and whether the company is profitable or not.
If an IPO is being priced at a premium to similar public companies, the prospectus should tell you why that is justifiable. For example, if the company trades at a higher P/E, it should be because of higher expected earnings growth.
Ask yourself: is this expected earnings growth feasible? That is how you decide if the company is properly valued relative to its peers.
Evaluating the underwriters
Underwriters are the investment banks handling the IPO process on behalf of the company. They determine the structure of the offer and market the shares to institutional investors.
The main consideration here is whether the underwriters have experience conducting the process for similar companies. If they have experience in the industry, they can bring expertise that can make the IPO process more likely to succeed.
You should also pay attention to the marketing. When a company has strong fundamentals, there will be strong interest from institutional investors. If the underwriters focus more on generating hype among retail investors, then you should ask questions about what institutional investors think of the company.
Confirming the lock-up period
The lock-up period is a 90-180 day window within which company insiders and early investors can’t sell their shares after the IPO.
Its purpose is to prevent these investors from dumping their shares right after the IPO, resulting in a downturn.
Though insiders won’t necessarily sell off, knowing the lock-up period can give you a feel for when selling pressure might increase and drag price down. This is especially important for traders who are looking to profit from IPO-related volatility.
And to that we turn.
How to day trade IPO volatility
Instead of waiting for months or years, some traders look for opportunities to profit from IPO volatility by going long or short on the IPO stock.
A stock’s first session may feature rapid breakouts, pullbacks, and changes in trading volume. But these moves can be difficult to interpret because the stock has little trading history.
Technical analysis can help traders interpret these movements. For example, traders can watch for candlestick chart patterns to predict if price is likely to go up or down after a few hours of trading activity.
However, those learning how to begin day trading should be careful about interpreting price movements around an IPO. Since there is little trading history, it’s hard to define a broader market trend, which makes any interpretation of retracements and breakouts difficult. Similarly, defined areas of value are non-existent, making it difficult to trade out of a defined zone.
Consequently, day traders should implement sound risk management controls like position sizing, stop-loss orders, and predefined risk-reward ratios, among others, before trading in any direction.
In conclusion, investing in an IPO or trading an IPO stock goes beyond following the market hype. Investors should focus on key fundamentals while traders looking to profit should recognize that it might take time before they can use technical analysis to profit from a new stock.
