How to approach trading an IPO (Initial Public Offering)

This guide will help you understand how IPOs work, which ones to monitor, and how to prepare your trading strategy, whether buying or selling post-launch. Some of the best opportunities may arise after the initial market activity on the first day.

Understanding what an IPO is

What is an IPO?

An initial public offering (IPO) occurs when a private company offers its shares to the public for the first time, transitioning into a publicly traded entity. This allows the company to generate capital from investors, which can then be allocated for business expansion, debt repayment, or supporting research and development efforts.

What does it mean when a company goes public?

A private company is typically owned by the founder(s), family, friends and employees. It's the end of one stage of the business’s life cycle and the beginning of another when transitioning to being owned by the public.

How does an IPO differ from regular stock trading?

IPOs are typically seen as riskier than regular stock investments because they often involve new or less-established companies. This creates uncertainty around the company’s future performance, making it harder to assess its value. As a result, IPOs can experience significant short-term price fluctuations. In contrast, investing in stocks of well-established companies is generally considered less risky as they have a proven track record of financial stability, and their stock prices are usually more stable.

How is the IPO price determined?

Who sets the IPO price?

Investment banks responsible for underwriting a company's public offering determine the IPO price by evaluating several factors, including the company's growth potential, comparisons to similar firms, and prevailing market demand conditions. With input from the investment bank, a valuation is established for the company, which is then divided by the total number of shares to be issued, resulting in the final price per share.

What factors influence the initial pricing of an IPO?

Several key factors influence IPO pricing.

• Growth Potential: Investors prioritise companies with solid growth prospects, as higher growth can lead to greater returns, influencing the IPO price.
• Competition: Investors compare a company’s IPO price to the market prices of competitors to determine if it is overvalued or undervalued.
• Economic and Industry Conditions: Broader economic trends and industry-specific factors, such as increased demand for specific sectors, can affect IPO pricing.
• Past Financial Performance: Underwriters assess the company’s revenue, profit margins, and overall financial health to set a price that appeals to investors.
• Demand: Strong investor demand can drive higher IPO prices, reflecting the company's perceived value.

Additional influences include stock market trends, the number of shares offered, and the company’s business model.

What is the process for a company to go public?

1. Starting the process early: beginning IPO planning as early as possible and engaging with diverse advisers helps gain valuable market insights and builds solid advisory relationships. The preparation process typically takes 0-24 months.
2. Reassessing the business strategy: To attract investors, a compelling equity narrative should showcase market opportunities, growth potential, and the company’s unique selling points.
3. Selecting the right market: Carefully evaluating different markets' listing, trading, compliance requirements, and tax implications ensures they suit current and future shareholders.
4. Building the public company board: The board should include independent non-executive directors with finance and industry expertise and a strong CEO and CFO. Gender and ethnic diversity are also increasingly required.
5. Initiating early-look marketing: Early marketing demonstrates the company’s ability to meet performance expectations, boosting investor confidence.
6. Evaluating financial information quality: Management must ensure financial transparency and accuracy to satisfy brokers and investment banks during IPO.
7. Reviewing internal financial controls: Private company financial controls may need adjustments to meet public company standards.
8. Evaluating Internal Resource Capacity: Resource planning should identify gaps and allow time to hire key personnel to manage the IPO and financial reporting.
9. Setting realistic valuation expectations: Companies will be guided on competitor valuations, helping set realistic expectations and avoid over-optimism by analysing industry trends.

How IPO trading works

How can I participate in an IPO?

• Research the IPO: Start by researching the company going public. Understand its business model, growth potential, financial health, and market position. Review the prospectus, which provides detailed information about the company and the offering.
• Open a Broker account: To participate in an IPO, you need an account that offers access to IPO shares. Eligibility requirements (such as account size or trading history) may apply.
• Indicate Interest: Once the company announces its IPO, you can indicate your interest in buying shares. This is often done through an online platform where you submit your request for a certain number of shares.
• Understand the Risks: IPOs can be volatile, with prices fluctuating significantly on the first trading day. Ensure you know the risks, including the potential for the stock to fall below the offering price.
• Place Your Order: IF you are allocated shares, you can purchase the stock at the IPO price. Depending on demand, the final allocation may be less than the number of shares you requested.
• Monitor the Stock After the Launch: You can track its performance once the IPO is complete and the stock starts trading on the exchange. Remember that IPO prices can experience significant changes in the days and weeks following the launch.

Can retail investors buy IPO shares at the offering price, or are they reserved for institutions?

Most IPO shares are typically allocated to institutional investors, with brokerages distributing the remaining shares to retail investors. While IPOs often gain significant media attention, initial trading days can be highly volatile. Some IPOs experience early solid performance, while others may struggle and see their stock prices drop.

What is the process for buying shares on the first trading day?

In the Primary Market: you can subscribe to an IPO before it goes public, allowing you to receive an allocation of shares at the same price and time as institutional investors. In the Secondary Market: once the IPO is complete, you can trade or invest in the shares alongside other retail traders based on the stock's performance after it begins trading on the open market.

Should I use a market or limit order when buying IPO shares?

Only limit orders are allowed before an IPO starts trading on the secondary market. This type of order lets you specify the maximum price you're willing to pay for the stock. Once the stock begins actively trading, you can then place a market order, which will execute immediately at the current market price.

What are the risks of placing a market order at an IPO launch?

With market orders, you ensure that the trade is executed, but you have no control over the price, meaning you’re not guaranteed a specific price at the time of purchase. This can be risky, especially during IPOs, as there may be potentially large price swings, leading to unexpected costs or gains.

Knowledge required for trading IPOs

Where can I find information about the company going public?

• Exchange Websites: Major stock exchanges often provide detailed information on upcoming IPOs.
• News Sources: Platforms like Google News and Yahoo! Finance regularly cover IPO announcements and updates.
• IPO Monitoring Services: Dedicated services such as IPO Monitor, IPOScoop, and Renaissance Capital IPO Center track and provide insights on upcoming IPOs. Additionally, Pepperstone proactively shares educational content on IPOs through email updates, web articles, or via your account manager, ensuring traders have the latest information and guidance to make informed decisions.

What are the key metrics to look at in the IPO prospectus?

• Financial Statements: offer insight into the company’s past performance and highlight internal or external risks.
• Capitalisation: This prospectus section outlines the company’s debt, equity from shareholders, and funds generated through operations.
• Growth Potential: A critical factor in setting the IPO price, reflecting the company’s ability to expand and generate future profits.
• Market Conditions: Assess overall market trends, economic indicators, interest rates, and investor sentiment.
• Intended Use of IPO Funds: Check how the company plans to allocate the money raised through the IPO, which can reveal strategic priorities.

How does the IPO lock-up period work, what is it for, and how can I benefit?

• Stabilising stock prices: The lock-up period prevents insiders from selling their shares immediately after the IPO, helping to stabilise stock prices and limit volatility.
• Cooling-off period: This timeframe allows the market to correctly price the shares based on supply and demand without insider influence.
• Increased liquidity: Option contracts may still trade during the lock-up period, providing some liquidity and contributing to price stability.
• Earnings reports: The lock-up period often covers up to two consecutive earnings reports, offering investors greater clarity on the company’s performance.
• Short-term selling pressure: When the lock-up period ends, insiders may sell their shares, potentially causing short-term selling pressure, increased volatility, and price fluctuations. Lock-up periods generally last 90 to 180 days; details are disclosed in the company’s prospectus.
• Investment strategy: If you anticipate a stock decline after the lock-up period expires, you could short the stock using CFDs or spread-betting. Conversely, if the stock price drops after the lock-up period, it could present a buying opportunity for those who missed the IPO.

What role do underwriters play, and what is their influence on the IPO’s performance?

Underwriters play a vital role in the IPO process, influencing its overall success:

• Evaluate the company: Underwriters assess the company's value and the risks involved in the IPO.
• Set the price: They determine the initial share price for the public offering.
• Buy and resell shares: Underwriters purchase shares from the company at the offering price and resell them to investors.
• Market the IPO: They promote the IPO through presentations, roadshows, and marketing efforts to attract investors.
• Adjust the offering: Based on market feedback, underwriters can modify aspects of the IPO, such as pricing or the issuance date.
• Reputation: A reputable underwriter signals quality, and a long-term relationship with them can benefit investors.

Benefits and risks of trading IPOs

What are the potential benefits of trading an IPO?

When a company becomes publicly traded, its visibility and market perception often improve, making it more appealing to investors who prefer investing in publicly listed companies. Additionally, listing on a stock exchange creates a liquid market for its shares, benefiting all market participants. Many companies historically have experienced significant stock price increases following their successful IPOs.

Are there any examples of highly successful IPOs?

Here are some examples of the most successful and well-known IPOs in history, along with percentage increases in share price:

• Visa (V): Visa's IPO price in 2008 was $44. The current price is approximately $291, indicating a rise of around 561%.
• Facebook (Meta Platforms): The IPO price was $38 in 2012. The current price is around $559, representing a 1371% increase.
• General Motors (GM): The IPO price in 2010 was $33. The current price is approximately $49, resulting in a 48% increase.
• Uber (UBER): The IPO price in 2019 was $45. The current price is approximately $75, reflecting a 67% increase.

Why can IPOs be more volatile than established stocks?

Stocks are often highly volatile during their first few months of trading due to factors such as the IPO launch price, market sentiment, and initial earnings reports. An aftermarket report is released which summarises the performance of a newly issued stock in the period following its IPO. This report is used to understand newly issued shares' demand and liquidity landscape, often through the end of the lock-up period, when insiders may sell their IPO shares. An aftermarket report typically includes an analysis of the stock's price movement in recent trading sessions, the company’s initial earnings post-IPO, and relevant company news that could impact investor sentiment and stock performance.

What happens if an IPO fails after going public?

When a company's IPO needs to raise more capital, it can use the extensive documentation gathered during the process, such as business strategies, financials, and projections, to attract alternative funding sources. If securing new investors proves challenging, the company may need to cut costs and delay new projects until financial stability is achieved. Companies can seek additional funding to support their operations in various ways if the initial IPO falls short of expectations.

Using historical Data

Can historical IPO data help predict future performance?

Historical IPO data can provide valuable insights into market trends, typical challenges, and factors contributing to successful public offerings. Analysing past IPOs helps identify patterns such as optimal pricing strategies, industry performance, and investor sentiment. However, it is essential to remember that past performance does not guarantee future results, as market conditions and company-specific factors can vary significantly.

What historical data points are most relevant for evaluating a new IPO?

IPO pricing and valuation, first-day trading performance, post-IPO volatility and trading volume, initial earnings and financials, industry performance and market conditions.

What have been the biggest IPOs in history, and how have they performed?

Some of the largest IPOs in history include Alibaba, Saudi Aramco, and Facebook. Their performance has varied and has been influenced by market conditions, investor sentiment, and company growth prospects. For example, Alibaba and Facebook saw significant growth post-IPO, while Saudi Aramco's performance was steady due to strong government backing and stable oil prices. Critical determinants of success or failure often include timing, pricing strategy, and the overall economic environment at the time of the offering.

Can the performance of competitors' IPOs offer insights?

Competitor performance can reveal investor interest, sector trends, and overall market sentiment, which help assess a new IPO. Observing how similar companies performed in their IPOs can provide benchmarks for pricing and demand, highlight potential challenges, and offer insights into investor expectations. This comparative analysis can be instrumental in crafting strategies for a successful public offering.