What is an IPO?
An IPO (Initial Public Offering) is when a private company transitions from being a private company to public company and it's at this point in time that Joe and Jane public can for the first time invest and own shares of the company.
By nature, IPOs are risky. Why? Well investors have relatively limited financial history on the company going public. Why? Because many private companies are smaller and don't have a long track record and prior to "going public," the private companies are not required to have audited financial statements.
So how does anyone know which companies are good buys and which ones will turn out to be bad investments? Good question...and a very tough question.
What should you look for when evaluating a new IPO?
Interestingly enough, similar analysis should go into an IPO and a company that is already public. Things like understanding their financial situation by analyzing their balance sheet, income statement, and cash flow statement. You should know the various financial ratios (Quick Ratio, Debt/Equity Ratio, Conversion Ratio, ROE, etc.) and how these ratios have been trending over time. Are they getting better or worse? You should understand the various drivers that will impact the company - both good and bad. What is the company's (TAM) Total Addressable Market? Who are their biggest competitors? What is the company's advantage and is their advantage sustainable? What Warren Buffett calls this a company's "durable competitive advantage."
And after you've thoroughly read through the company's prospectus (including the foot notes), answered an additional 101 questions or so, you can then move on to trying to value the company. While there are several ways, from Price/Sales, Price/Earnings, Price/EBITDA, to name a few, generally the most robust way is to do a comprehensive discounted cash flow analysis (DFC). A DFC is a process that uses the projected future cash flows of the company into perpetuity and discounting them back based upon current risk and interest rate levels. Once you have this DFC you can then stress the results by changing various assumptions, like initial cash flows, growth rates, and discount rates to see how the valuation changes.
So build a DCF, then take these various DFC valuations and compare this with the IPO valuation to see if buying into this company make sense.
What makes buying an IPO even more difficult to evaluate is the fact that many of them don't have positive cash flow. So how do you value a company that doesn't make money? Again, another great question and another difficult one. The big driver will be the assumptions used in what the company might look like in several quarters or even several years down the road. So playing fortune teller becomes a necessary requirement. Something, I'm typically not a fan of. Uggg.
So having read all this, while history is never an accurate forecast of the future, sometimes it can provide valuable sign posts with which to gain some insight. If you have a high tolerance for taking big risks then maybe allocating a portion of your investment portfolio to IPO's might be for you. However it would be prudent to understand and recognize that buying IPO's is the quintessential, "buyer beware" transaction.
-Paul R. Rossi, CFA