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IPOs: Consider the Risks Behind the Hype

An initial public offering (IPO) is the first public sale of stock by a private company. Companies tend to schedule IPOs when investors are feeling good about their financial prospects and are more inclined to take on the risk associated with a new venture. The U.S. IPO market was strong in 2018, reflecting the surging stock market and the robust economy.1

Inside Out

Although IPOs can sound enticing to an average investor, company insiders may have the most to gain from a public offering. The higher the price set on IPO shares, the more money the company and its executives, employees, and early investors stand to make.

Even so, the IPO process is important to the financial markets and to investors in general, because it helps fuel the growth of young companies and adds new stocks to the pool of potential investment opportunities.

Pop or Fizzle

When IPO share prices shoot up on the first day of exchange trading, it’s referred to as a “pop.” A significant first-day gain may suggest that investor demand for the company’s shares was underestimated. Of course, this doesn’t mean that the company will outperform its peers in the long run.

One catch is that it is often difficult to obtain “allocated” shares that can be purchased at the IPO offering price, the price at which insiders are selling to the market. Investors who don’t have the opportunity to buy shares at the offering price can buy the stock after it starts trading on the exchange. However, much of an IPO’s pop can occur between its pricing and the first stock trade. This means investors who buy shares after trading starts often miss out on a large part of the appreciation.

Investors who buy IPO shares on the first day might even pay inflated prices, because that’s when media coverage, public interest, and demand for the stock may be greatest. Share prices often drop in the weeks following a large first-day gain as the excitement dies down and fundamental performance measures such as revenues and profits take center stage.

Back to Reality

A young company may have a limited track record, and an established one might have to disclose more information to investors after it becomes publicly traded. If you’re interested in the stock of a newly public company, you should have a relatively high risk tolerance, because shares can be especially volatile in the first few months after an IPO. You might consider waiting until you can evaluate at least two quarters of earnings. Careful research is important for all investments, but recent IPOs may require a higher level of scrutiny.

The return and principal value of all stocks fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. Investments offering the potential for higher rates of return also involve a higher degree of risk.

 

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