IPOs 101

How to Profit from Initial Public Offerings

IPOs 101
July 11, 2014

You have probably heard or read stories about investors who have struck it rich by getting in on a hot initial public offering, or IPO. If so, you may be wondering how you, too, can profit from an IPO.

What Is An IPO?

An IPO is the first (or initial) sale of stock to the investing public. IPO went from a fairly obscure business and investing term that most people had probably never heard to part of the common vernacular during the high-tech, dot-com boom (and subsequent bust) of the late 1990s. At that time, new technology and Internet companies were going public left and right — and often making their founders and early investors very rich in the process.

Of course, many of these companies went belly-up within just a few years, as they failed to demonstrate economic viability. Nevertheless, some of the investors who got in on the IPOs and sold their stock before the companies tanked were still able to profit handsomely.

The days of the dot-com boom and bust are well behind us, but that doesn't mean companies aren't still issuing IPOs. In fact, the latest hot IPO trend has been public offerings by social media companies like Facebook, LinkedIn and Twitter, which reminds some investors of the frenzy over new Internet company IPOs over a decade ago.

Profiting From an IPO

While it is possible for ordinary investors to get in on IPOs like company founders and insiders often do, this is not likely. To see why, you need to understand how the IPO process works.

An IPO is usually underwritten by an investment bank, which is responsible for marketing the IPO shares to potential investors via an initial prospectus. This document, which is sometimes referred to as a red herring, includes all the relevant information about the company. As part of their efforts to market the IPO, the underwriter and company executives often go on a road show (or "dog and pony show" as it’s sometimes called) where they pitch the IPO to big institutional investors. These investors will have the opportunity to purchase shares in the company at a discounted price from the regular trading price.

You will notice in this process that pitching the IPO to small, individual investors usually is not a priority for underwriters. There are three main reasons why it is difficult for average investors to get in on an IPO:

  1. Big institutional investors are where the big money is. It is much easier to sell one institutional investor a million shares of stock than to sell 10,000 individual investors 100 shares of stock.
  2. The institutions that are being pitched are usually regular clients of the investment bank and brokers who are underwriting the IPO. Therefore, they are naturally going to get the first crack at investing in the IPO.
  3. Even if you are a client of an institution that is participating in the IPO, you will probably have to have a very high net worth to be offered shares in the IPO.

Can You Profit From IPOs?

Just because it is difficult to get in on an IPO doesn’t mean there aren’t opportunities for individual investors without a vast net worth to profit from IPOs. Once the IPO's stock is offered on a public exchange, any investor can buy or sell it. And while successful IPOs tend to get all the headlines, companies' stock prices often fall below the IPO price quickly — sometimes even on the same day of the IPO.

In fact, not participating in an IPO can end up being a blessing in disguise if the stock price ends up trading below the IPO price soon after the company goes public. The much-ballyhooed Facebook IPO on May 18, 2012, provides a good example.

The IPO price on Facebook shares was $38. But at the end of the first day of trading, the shares stood at just $38.23, up only 23 cents. And by August 20, just 68 days later, the share price had fallen all the way to $20.01. Patient investors who waited out all the initial hoopla and bought shares at this time have been handsomely rewarded — Facebook stock was trading at over $64 a share in mid-June of this year.

Another possible way to profit from IPOs is to invest in similar companies during the run-up to a company’s IPO. Investor excitement about certain companies’ IPOs often ends up raising the stock price of companies in the same industry. Again, social media companies are a good example: Shares of Facebook rose from around $41 in late August of last year to over $47 on November 7 — the day Twitter went public.

While it is rare for ordinary individual investors to get in on an IPO, there are still ways you can profit from IPOs. The key is being patient and observant, and carefully researching potential investment opportunities. A diversified portfolio that includes stocks plays a vital role in helping you to save for retirement. Let the free Retirement Planner by MoneyTips help you calculate when you can retire without jeopardizing your lifestyle.

Photo ©iStockphoto.com/nyanza

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