The Pros And Cons Of Investing In An Ipo (plus, How To Do It)

There's something especially appealing about being first to the table. That's a big part of why initial public offerings (IPOs) attract so much attention. Instead of waiting until a company has spent years or even decades on the market, an IPO gives you the chance to buy a stock when it first begins trading in public markets.

You may also get to reap the benefits of the famous first-day "pop" in price. But buying early doesn't necessarily mean you're getting a good price, or even a good investment.

Newly public companies often arrive with lots of hype and valuations that can be difficult to justify. And while some IPOs go on to become major winners, others stumble and take years to recover.

This doesn't mean you need to steer clear of all IPOs. But it does mean you should understand the pros and cons of an IPO and how to spot a potential gem from a dud before buying in.

What are the pros of investing in an IPO?

IPOs aren't inherently better investments simply because they're new, but they can give you exposure to new businesses and growth trends.

"To me, diversification and growth are the two key advantages to owning new stocks," says Matthew Kennedy, senior IPO market strategist at Renaissance Capital. "Most popular index funds, including those that track the S&P 500, do not have many new stocks."

Renaissance Capital's analysis shows that companies in the S&P 500 have been trading for more than 40 years on average.

"Meanwhile, new stocks are often pure-plays on some of the most cutting-edge technologies and growth concepts," Kennedy says.

This can make IPOs a way of broadening your portfolio, but it doesn't mean buying an IPO automatically makes you diversified. You're still buying an individual stock with company-specific risks.

Another potential advantage comes if you can buy shares at the IPO price before public trading begins. Since 1980, the average first-day gain on IPOs is 19%, according to research (PDF) by Jay Ritter, director of the IPO Initiative and professor emeritus of finance at the University of Florida's Warrington College of Business.

But "possibility" is doing a lot of work there. Getting shares in the most popular IPOs can be hard, and a first-day gain is far from guaranteed.

What are the cons of investing in an IPO?

The same qualities that make IPOs exciting also make them difficult to evaluate.

"IPOs don't have a trading history," Kennedy says. "They don't have a management team with a public track record of setting and meeting expectations."

What they often do have in spades is hype, but this can do more harm than good for long-term investors. "Great excitement can result in overvaluation, so that even great companies become so overvalued they have little upside," Kennedy says.

Nor does every IPO enjoy the first-day price "pop." In fact, since 1980, about 24% of IPOs have fallen on the first trading day, according to Ritter's research.

It's also generally easier to get shares in IPOs that drop on the first day than ones that pop because the poppers typically have a lot more demand, Ritter says.

Management teams can be very strategic about when they choose to go public, according to Kennedy: "You may be seeing a business that's benefitting from tailwinds that are ultimately unsustainable."

Historically, IPOs have also underperformed the broader market in the first three years after going public for investors who bought at the market price on the first day of trading, Ritter says.

There's an important distinction to make, though: Since the 1980s, IPOs from companies with more than $100 million in annual revenue produced an average three-year buy-and-hold return of 36.4%, whereas those with annual revenue less than $100 million returned just 5.3%, according to Ritter.

So, "revenue is a better predictor of future returns than profitability," he says.

How to evaluate an IPO before you buy

If after knowing all the pros and cons, you still want to buy an IPO, the next step is to understand how to tell a good prospect from a bad one. The IPO prospectus is a wise place to start. It won't tell you how the stock will perform once trading begins, but it can tell you a lot about the business you're actually buying.

"Strong growth, expanding margins and a solid balance sheet," are the three characteristics Kennedy generally looks for, although he adds that a successful investment doesn't necessarily need all three. He also recommends digging into management's discussion and analysis, or MD&A, rather than relying only on the full-year numbers.

"Sometimes you'll find a company with a good fiscal year, but problems emerge when you drill into the latest quarters," he says.

Since many IPOs have little or no profit, Kennedy often uses sales and adjusted EBITDA instead of traditional price-to-earnings ratios.

Adjusted EBITDA, or earnings before interest, taxes, depreciation and amortization, is "very useful as an apples-to-apples operating margin, but investors should always double-check how the company is calculating it, and what the actual free cash flow looks like," he says. "Since adjusted EBITDA is not GAAP, companies can sometimes be aggressive with add-backs."

Ritter also favors price-to-sales (P/S), which compares a stock's price to a company's sales.

SpaceX (SPCX) provides an extreme example. The company went public in June at a P/S ratio above 90, according to Ritter.

"At such a high ratio, almost everything has to go right for SpaceX to grow its revenue and profits enough to justify such a high valuation," he says. The higher the valuation, the more future growth investors are already paying for and the less room the company has to disappoint.

Ritter has one more red flag: Stay away from IPOs priced at $5 per share or less. "These IPOs have generally been a disaster for investors," he says.

How to invest in an IPO

Once you've identified a good IPO prospect, the path gets technical. There are two basic ways to invest in an IPO: Try to get shares at the IPO offer price or wait until the stock begins trading publicly.

Some brokerage firms give eligible customers access to IPOs before trading begins. But requesting shares doesn't mean you'll receive them, especially in popular offerings.

Also keep in mind that many brokerage firms have policies to discourage selling on the first day or shortly thereafter. If you do sell shortly after trading, you may be locked out of future IPOs.

The easier way to invest in an IPO is to simply wait until trading begins. Then, you can buy shares through your brokerage firm as you would any other stock. You may pay more or less than the IPO price, but you won't have to compete for an allocation.

That said, "no one needs to buy on day one," Kennedy says. He recommends deciding what you're willing to pay before trading starts, rather than letting headlines or fear of missing out set the price for you.

Instead of chasing the hype, you can put the stock on a watchlist and continue following its valuation and results.

Ultimately, "investing in a company going public should be treated no differently than investing in any other individual stock," Ritter says. This means looking beyond the headlines to the company's financial health, prospects and valuation, and being willing to walk away when the price doesn't make sense.

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