Three Reasons to Not Buy a Company’s Stock During an Initial Public Offering (IPO)

Every now and then, a company’s Initial Public Offering, or “IPO”, will cause mass hysteria amongst many investors. Oftentimes, it is an IPO of a company with a popular product that caters to the masses.

Unfortunately, investing in IPOs with the assumption that one will make a quick profit is misguided. While investing in a company that’s recently gone public can of course be warranted, rational thought and ample research should be exercised prior to making any investment.

With that in mind, here are three reasons to not buy shares during an IPO.

 

#1. “If I’m buying shares during an IPO, I’m an “early investor.” Surely I’ll be profitable when everyone else wants to buy later.”

               While you may be considered an early investor for purchasing shares on a public exchange, you are certainly not an “early investor.” Generally, a private company that is in growth mode will likely have had multiple rounds of private equity cycles, where investment firms and private investors will buy ownership of companies to provide capital to the growing company. These are the parties who “got in early,” so to speak.

#2. “Everyone is talking about this IPO – demand will be so high and stay that way.”

It’s true that demand for most IPOs is higher than the supply of shares, which generally leads to higher prices when the stock hits the exchange. Usually, however, the demand for shares can fizzle as the IPO hysteria fades, and the supply will likely increase along with it. With IPOs, owners and employees are required to hold their shares for a period after the IPO – generally around six months to a year. This is known as a “lock up period” – a requirement that allows the stock price to stabilize during the initial phases of the publicly traded stock.

The conclusion of a lock-up period can often bring a glut of share supply. Owners and employees who wish to sell the shares at the inflated prices driven up by initial public demand can suddenly turn a seemingly hot stock into one that has a lot of downward pressure on its share price.

#3. “If a company is going public, it must mean that it is in great shape financially.”

There are a few problems with this rationale. For one, it’s unlikely that there is ample information on a private company’s fundamentals, especially compared to an established publicly traded company. In addition, a company’s immediate run up in price after its IPO can lead to lofty valuations. When investing in an IPO, never assume a company has a healthy balance sheet, is growing exponentially, or is even profitable – because oftentimes they are not.

 

Investing in IPOs can be a wise investment decision. However, like all other investment decisions, it’s vital to perform research and due diligence before investing. Be sure to avoid the temptation of emotional investing; getting caught up in the media hype of a highly-anticipated IPO can lead to baseless investment purchases that can wreak havoc on your portfolio.

 

*Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss. Investing involves risk including loss of principal.