An initial public offering, or IPO, is the first time a stock is sold by a private company to the public.
Typically you will see IPOs being issued by younger, smaller companies seeking capital to expand. Sometimes, however, larger companies that wish to become publicly traded will also issue IPOs.
Just like any other stock, IPO stocks are subject to supply and demand - they will sell for whatever price a person is willing to pay.
But because IPOs haven't been tried and tested in the market, there is a lot of analysis - even guesswork - behind setting a price.
Thus, there is a certain "art" to pricing an IPO.
The company planning an IPO will appoint a bookrunner to help it value the share price.NYSE:JPM), and Morgan Stanley (NYSE:MS) are good examples.
The bookrunner operates as an underwriter, and will maintain and manage the books of security offerings that are part of the new equity issue.
"There are two parts an underwriter considers when pricing an IPO. One part is mechanical, and one part is more 'reflective'," explains Money Morning's Capital Wave Strategist Shah Gilani.
"On the mechanical side, the investment bankers become intimately aware of the nexus of the company" Gilani said. "They have to compare business models, look at the competition, and know all the metrics."
So essentially, the mechanical side is all about crunching the numbers and determining what the company is worth.
But, as Shah points out, the reflective side is equally important:
"The reflective side deals with how the issue reflects itself vis-à-vis the market. And there are several pieces to that. Institutional traders have to figure out where to price the company, and what it will do when it goes into trading. It's about the market perception of the company and what people are willing to pay."
En masse, the process of pricing IPOs is straightforward but arduous, and every company is different. If the pricing is off, disaster may ensue.
Whether you over- or underprice an IPO can have significant real-life consequences to the company issuing it.
What happens when an IPO is OVER-priced?
"If an IPO is hyped sufficiently, and once its shares are released for free market trading and if it has been 'overpriced,' the consequences are huge," Shah posited.
By overpricing the issue, the issuer will be momentarily happy because a large amount of capital was raised.
In turn, the investment banker(s) acting as bookrunner and underwriter will also be momentarily happy because they created demand and capital for the issuer.
"But," Shah adds, "That's all momentary."
"If there is little open market demand once the shares start trading, the buyers who have IPO shares to sell will sell them in order to capture the opening price before it starts to fall. That selling, and the short-selling that will follow (because traders see the new issue is overpriced) will push the stock down," Shah explains.
"That's bad for those who paid the high price and are watching losses mount...It's bad for the insiders who can't sell for months... It's bad for the employees who see the value of their option grants, etc. slip... And it's bad for the underwriters who have to now "support" the stock so it doesn't slip too far."
But those negative effects aren't the end.
"Worst of all," says Shah, "Besides the mechanics above, the public perception of the stock's début is that it's a stinker. It comes out with all this fanfare and it falls? What does that say? It's not good."
Clearly, overpricing an IPO can be a dangerous thing.
What happens when an IPO is UNDER-priced?
"The only real consequences of underpricing are the issuer didn't get the most capital raised and the bankers look like they left too much on the table, so they have egg on their faces," Shah explains.
"BUT, if the stock soars everyone else is happy. The bankers are forgiven. The issuer gets over it because his successful IPO with its soaring price tells the world...
'HEY this is a hot company!'
"All the insiders who can't sell yet and the employees with grants are all thrilled. It brings huge attention to the company if the stock soars when it opens."
So, the consequences of under-pricing are bad, because a company could lose out on a lot of capital, but not as bad as if the IPO is over-priced.
This explains why investment bank underwriters tend to err on the side of underpricing.
When it comes to investing, IPOs tend to attract speculators.
Shah isn't hot on IPOs himself, unless he is allocated stock that he can flip at the open for a nice, free gain.
"There's too much 'speculation' attached once they start trading. I prefer to see how the IPO opens and how it trades, and then unless it's doing everything I expect and more, I'll wait until I can feel comfortable with the stock price being an appropriate and meaningful reflection of the earnings potential of the company."
For more of Shah's fascinating insider breakdowns, check out his investing tips on how to make money now that the Fed has signaled the beginning of the end of quantitative easing here...
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