Should I invest in IPOs?

Q: My friend recently told me that she made a lot of money from an IPO (initial public offering) whose share price had doubled during the first week of trading. I regretted not buying it when it was first offered to me by my broker. Now, there is another IPO coming up and I am not sure if I should buy this time around. Is it safe to buy?—Felyn Bacurin by e-mail

A: While IPOs tend to give extraordinary returns, especially when the market is doing well, there is no guarantee it will be profitable all the time. Buying an IPO at offering price does not mean you are buying it at the lowest price.

The IPO price is simply the value that the owners of the company are willing to sell to the public. You may or may not agree with the price, depending on how you will evaluate the merits of the offer. You can avoid buying it if you find it expensive or you can grab the offer if you think it is promising.

Investing in an IPO is like buying regular stock that needs careful research. You don’t buy an IPO because your broker asked you to or you see everyone buying it. Sometimes the underwriters responsible for the IPO hype the stock too much that you feel you are missing an opportunity of a lifetime. Many people buy IPO with the intention of unloading it immediately for quick profit. This can be a risky strategy if you buy without knowing much about the IPO. Sometimes this may work well when the market is good. But if you get caught by a bad market or the market simply does not favor the IPO, you will have to hold it for the long term or risk huge losses to get out.

The key to profitable IPO investing is to know the company behind the stock. Can you comfortably explain the business model of the company? How attractive is the industry where the company belongs? How reliable is the earnings power of the firm based on its financial history? How stable is its financial position? How trustworthy are the controlling shareholders? How capable are the members of the management team? Most of the information you will need can be found in the IPO’s prospectus.

Once you have become familiar with the company, the next step is to evaluate the IPO price to see if the offer is acceptable. You want to know how much you can potentially profit from investing in IPO. One way to check is by getting the P/E ratio of the stock based on projected income. If the IPO has P/E of 15x and the average P/E of the sector to which the IPO belong to is 25x, you can more or less expect the stock to rise somewhere near the average. The bigger the upside potential, the more attractive the IPO.

However, It may not be easy to find IPO with attractive P/E valuations because the tendency is for company owners to raise as much capital as possible from the public in exchange for limited number of shares, which normally result in large premium.

You can consider buying IPO at high P/E if you think the company can justify its premium with the expected increase in earnings from expansion. How much of the IPO proceeds will the company use to invest in expanding the business? Note that there are IPOs that raise funds to pay for existing loans, which do not add so much value. So, the more funds allocated for investments, the better the prospect for higher income.

Consider also the liquidity of the IPO. How much of the company’s outstanding shares shall be available for the public to trade? If the free float is small, say at minimum of 10 percent, you can expect the stock to be more volatile because there are only a limited number of shares available. Higher volatility means higher risk because the share price can swing at a large percentage in a few days if it is actively traded.

If you are investing for the short term, this can be a good opportunity for you. But if you are investing long-term, prefer an IPO with bigger free float, say 25 percent or more so that there is higher stability in the share price movement. Institutional investors, such as foreign funds, prefer larger free floats so they can trade with significant number of shares without necessarily affecting the share price.

When you invest in an IPO, it is important for you to define your investment strategy. IPOs can be volatile in the first few weeks of listing. It can shoot up high quickly or fall immediately. You need to manage your risk by setting a target price to sell. If your stock falls badly, you also need to set a price to cut your losses.

Ideally, you need to sell your IPO at a good price when you have the opportunity to do so because it may not stay that way for long. Every IPO has a lockup period which prohibits company insiders, such as officers and employees, from selling their allocations. Lockup period normally lasts a year. So when this period expires, you can expect the insiders to cash in on their profits. When this happens, there will be tremendous downward pressure on the stock price because of the excess supply in the market.

Yes, it is safe to buy an IPO if you know what you are buying. Don’t buy just because everyone is going crazy about it. Buy because it is a good investment.

(Henry Ong is a registered financial planner of RFP Philippines. To learn more about financial planning, attend our FREE personal finance talk on May 8, 7 p.m. at PSE Ortigas. To reserve, email info@rfp.ph or text <name><email><RFPinfo> at 0917-3464126.)

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