Should you invest in IPOs?

How stock market flotations work, and whether it's a good idea to invest in them.

Have you ever wondered what an IPO is? And are they a good way to make money?

In this video, I explain how IPOs work, and whether theyre a good opportunity for investors.


So, what exactly is an IPO? It stands for initial public offering. They're also known as floats, or new company listings.

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Basically, you might have a company that's owned by private shareholders, there's no listing on the stock market, it's worth, say, roughly £100 million. The company then comes to the stock market, sells some of its shares to new investors they may pay £30 million for 30% of the company, and then the company has 30 million quid which it can use for investment and you've also got new owners mixed in with the old investors, and you still own 70% of the company. That's basically how they work.

So, why do companies do IPOs? Well, one reason as I just said is to raise money, to grow the business, to invest. Another reason sometimes is the current owners of the company just want to sell up and cash in. Also companies often think they may be able to recruit better staff if they can give them shares or share options to incentivise them.

Now, IPOs have had quite a lot of exposure in the last couple of years. We've seen some pretty big IPOs both in the UK and the US. In the US we've had Facebook Twitter, and LinkedIn. Here in the UK we have Royal Mail, which last year, obviously got a lot of publicity and we've got Saga coming up soon. So, it's a good time to think a bit more about IPOs.

And I guess the big question is, should private investors invest at the IPO?

Just to be clear, what normally happens is the company wants to list on the stock market, so they go to an investment bank or investment banks, you take the company around the big institutional shareholders and then those institutional shareholders commit to buy at the offer price, say £3 a share. And sometimes, only sometimes, private investors also get the opportunity to buy in at that offer price, £3 a share.

So, private investors had that opportunity with the Royal Mail float. They're going to get that opportunity with the Saga float. With a lot of the smaller IPOs the private investors can't buy in at the offer price. They just have to wait till the shares are floated on the stock market and pay whatever the share price is on that day.

Now you might think, well, if you get the opportunity to buy in to something like Royal Mail, it's an obvious one-way bet, you're bound to make a profit. Royal Mail listed an offer price of £3.30. It's been as high as £6 since then, and right now it's still well over £5. So, it's been an easy way to make money. And when you think back to the big privatisations in the 80s BT, British Gases again, , private investors were able to get in there, just kind of stacking and make easy profits.

But, actually buying in at an IPO isn't a one-way bet. Sometimes the share price doesn't move in your direction. Think back to Facebook. A couple of years ago it listed at $38. The shares quickly fell as low as $18. There was no quick initial share price boom, although they have since then moved back up well above $38, but there wasn't a quick buck to be made.

And in the UK, Merlin Entertainments, they listed recently. Their offer price was £3.50. Okay, it went to a peak of £3.90, and it's now about £3.50. So, you'd have made a profit, but nothing amazing. And then you got Pets At Home, another recent listing. It listed at £2.45. It's now bobbing around £2.10. You wouldn't have made a profit there either. So, IPOs can make you money, but they're not a one-way bet.

And I think you really have to ask yourself, if you're thinking about investing in an IPO, why are the owners selling? Why is this IPO happening?

If they're raising money to invest and grow, I think that's more attractive. But, if they're just wanting to sell out and cash in, I think that's a big warning sign. And added on to that, if they're trying to cash in and they're also lumbering the business with a lot of debt, I think that's pretty much a red flag saying "no, don't do it".

Think back to Debenhams, it listed in 2006. It had been owned by private equity firms. They had sopped loads of cash out of the business. They'd lumbered lot of debt onto that business. And it's been very hard for Debenhams since then to pay off that debt, to also grow, and reward the new shareholders at the same time. And its proven to be a very bad investment. I think Manchester United's another more recent example. It listed with a lot of debt. I don't think that's going to be a good investment in the years to come.

What about buying in to an IPO after it's happened in the first days or weeks that it's on the stock market? Well, I think that's a pretty risky thing to do. Sometimes it will work out, but even in those first few days of listing I think the institutions will often have a lot more information about the business than private investors. They've met the directors. They've seen what's called the company road show.

Once a company's been listed for a month or two things will have settled down, more information will have leaked out to the press, it will be more of an even playing field and that's probably a better time to buy in then. And you'll just treat it like any other share, look at the financials, think about the company's prospects, look at what's happening in that part of the economy, what's happening with the competitors as well.

Since I think initial IPOs can be very risky to buy in early, IPOs are often very volatile with the share prices and that's especially true if you're looking at some of those sort of hot sectors like social media Facebook and Twitter.

So, with IPOs I think you can make money, but you do need to be careful. And the best thing to do is to think about them as you would any other share. Just think about the financials and the prospects. Don't get over excited, don't get caught up in the euphoria, and then you'll probably do just fine.

So that's it for today. I'll be back with another video soon. Good luck with your investing.

Ed has been a private investor since the mid-90s and has worked as a financial journalist since 2000. He's been employed by several investment websites including Citywire, breakingviews and The Motley Fool, where he was UK editor.


Ed mainly invests in technology shares, pharmaceuticals and smaller companies. He's also a big fan of investment trusts.


Away from work, Ed is a keen theatre goer and loves all things Canadian.


Follow Ed on Twitter or Google+.