The Motley Fool

Never Judge An IPO By Its Cover

In some countries it is known as a flotation. In others it is called an Initial Public Offering or going public. Some simply call it an IPO. But have you ever thought about what it actually means when a company floats its shares onto the market for the first time?

We know what it isn’t. We know it isn’t some altruistic act by the owners of a company to let you have a piece of their business on the cheap. Far from it, even though many companies that float on the stock market might claim they want their “members”, “fans” or “customers” to partake in the future growth of the business.

Where’s the door?

In some cases an IPO is a way of raising additional capital for the business. In other instances, an IPO is simply a way that existing owners can realise their investments by selling a portion of their business. If you think about it, these owners could just as easily dispose of their stake to a private buyer – and some do. However, most opt for an IPO even though it is not only costly but it also forces a business to disclose information that it could otherwise keep private.

Thing is, an IPO generally allows existing owners to achieve a better price for their stake in the business. That is probably why many companies are choosey about where they launch their flotation. For instance, a Chinese-based company might achieve a higher valuation if its shares are quoted on say, the Hong Kong or Singapore stock exchanges rather than on the London Stock market. Consequently, they are more likely to float in the East than in the West.

All a Twitter

Just recently, Twitter announced plans for an Initial Public Offering. It said it had submitted paperwork to go public. However, it was short on information regarding both the time frame and the financial details of the flotation. That didn’t stop the public relation machinery from kicking into action, though. One story doing the rounds identified an angry passenger who successfully complained about lost luggage by purchasing a “promoted tweet” on the social network site.

Clearly it is in the interest of a company and its underwriter to drum up as much publicity ahead of a flotation. It not only helps put the company in a good light but it can also help garner demand for the shares.

That is why the Facebook flotation was deemed a success even though the shares sank after the flotation. It meant that the underwriters did a good job at persuading investors to part with more money than necessary. Interestingly, if the shares had risen sharply, it would have meant that the underwriters had sold the shares too cheaply.

Hindsight is 20/20

Of course hindsight is wonderful thing. But it is worth bearing in mind that an IPO is designed to achieve the best possible price for the existing owners. So if you are interested in buying IPO shares, it is crucial to examine the company’s trading history. It is also worth looking critically at how much “lipstick” has been applied to the balance sheet to make it appear more acceptable. For instance, has debt been massaged ahead of the flotation?

In terms of debt it is also worth looking at whether the company is saddled with lots of it. If so, does the company plan to use the proceeds of the flotation to pay down its loans? Additionally, what else does the company plan to do with the money raised? In other words, how does the company plan to grow the business?

Make me rich

If the proceeds are simply to make the existing owners rich and satisfy creditors, then that would put a totally different complexion on the flotation. It is also a good idea to look at how much of the business will be owned by management after the IPO. Ideally, you would want them to have a significant stake in the business. The more they stand to lose, the better it could be for new shareholders.

In most IPOs, the odds are stacked against new investors. Consequently, it is hard to know when a float is overpriced. One way around the problem would be to build into your valuations a wider margin of safety.

Alternatively, it may be prudent to wait until after the company has been on the market for at least a while before buying shares. That is, if you are still interested in buying the shares after the euphoria has subsided. By that time, you should have more information to make a better judgement than simply judging the IPO by the cover of its glossy sales brochure.

A version of this article first appeared in the Independent on Sunday.

The Motley Fool’s purpose is to help the world invest, better. Click here now for your FREE subscription to Take Stock — Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo, Take Stock — Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.

Like us on Facebook to keep up-to-date with our latest news and articles. The Motley Fool’s purpose is to help the world invest, better. 

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.