Welcome to Ameritrade Plus University
  Investing in IPOs
Top 10 things
The details:

Getting a piece of the action

Be careful what you wish for

Prospectus, price and performance
Take the test
  Setting priorities
  Making a budget
  Basics of banking
  Basics of investing
  Investing in stocks
  Investing in bonds
  Buying a home
  Investing in mutual funds
  Controlling debt
  Employee stock options
  Saving for college
  Kids and money
  Planning for retirement
  Investing in IPOs
  Asset allocation
  Hiring financial help
  Health insurance
  Buying a car
  Home insurance
  Life insurance
  Futures and options
  Family law
  Estate planning
  Auto insurance

|> About Money 101

investing 101

  Prospectus, price and performance
Do your own due diligence before you buy an IPO.

Many of the items listed above will be in the offering prospectus, but good luck finding them quickly or understanding the business babble in which the information is couched. Prospectuses are often 50 to 80 arcane pages that require the skills of an accountant and a lawyer to decipher.

Prospectuses are also really scary. To avoid lawsuits from disgruntled shareholders, companies tend to list in exquisite detail every possible thing that could go wrong with their business. When you are done with the document, you may wonder why anyone would even think of buying the shares.

Summaries of the salient numbers and information (such as the identities of the top shareholders) should be available from your broker. Search the World Wide Web for reports from outside analysts and compare these with your broker's. The most important part of the prospectus, of course, isn't the words, but the numbers -- those in the balance sheet. Take a hard look and ask the questions prescribed by Norman Brown in "Profiting From IPOs & Small Cap Stocks" (New York Institute of Finance/Prentice Hall, 1998):

"Are the new company's finances strong enough to keep it going even if profits do not live up to expectations -- or, if profit growth is on target, to provide for continued expansion?"

Regardless of how promising a company on the public launch pad may be, this does you no good if too few investors agree, impeding the stock's performance, or if too many agree too soon, escalating its opening price to the point where there's little room for share-price growth.

Of course, when your broker makes good on your quid pro quo arrangement and calls you with a recommended IPO, there is no price, only an expected range. Your ability to predict the actual opening price, as well as the stock's price movements in the weeks to come, will mean the difference between making quick money and getting stuck with a dog.

Once you have the range, try to pigeonhole your broker on what the actual level on interest will be in the investment community -- then seek more objective intelligence on this from sources like the Wall Street Journal or various services that project the opening price. One of the more affordable such services for retail investors is the IPO Financial Network. (You can download a copy of any offering prospectus there, as well.)

Whether an IPO will be undersubscribed or oversubscribed before the opening is determined by the ratio of the level of interest to the number of shares being offered. While this ratio doubtless has an effect on what the opening price will be, prudent principals in any IPO should be weighting other factors more heavily. Chief among these are stock prices of companies of comparable size in the same industry, relative to their earnings.

Based on this kind of information, the investment banking firm handling the deal recommends a public offering price at a meeting that is usually held the night before the opening. Thus, you won't have time to evaluate this price after it's set.

Instead, your advantage lies in evaluating the expected range by comparing it with those of comparable companies. If these benchmarks are priced substantially lower than the midpoint of the expected opening range, then this is a stock you probably want to stay away from. But if you deem the top of the range to be reasonable, based on comparables and your gauge of investor interest in the stock, then you may want to go for it.

If the stock tanks during this period -- that is, if it dips below its opening price -- consider holding onto it for a while, assuming it doesn't fall too far. But if it soars from the start and keeps rising dramatically for several weeks, you may want to consider selling after a few months. The reason: Though they are launched by worthwhile companies, many IPOs take on a life of their own after a few days, with latecomers pushing the price higher and higher in almost manic fashion.

This is fine for those in on the ground floor (if these folks include you, remember to send your broker a bottle of booze for Christmas), but you can't expect the high price to be sustained indefinitely. Frequently, IPOs that start out like gangbusters reach a plateau after six months or less, in part due to profit-taking from those aware that the hype that developed in the initial weeks has doubtless inflated the stock beyond its actual worth as determined by earnings.

Whatever you do, don't jump too soon -- into or out of an IPO. Evaluate them carefully. If you get in and the price dips immediately, investors may begin buying it up at bargain prices, thus driving it up -- assuming the company has the worth that your research revealed. If your fledgling IPO springs out of the gate, resist the temptation to sell it in the first few days. This practice, known as flipping a stock, will alienate your broker and probably cut off your access to future lucrative deals.

Next: Take the test


© 2003 Cable News Network LP, LLLP.