What You Should Know About IPOs
By Dmitriy Gurkovskiy, Chief Analyst at RoboMarkets
IPO means initial public offering. Any company that wants to grow its business must decide on its financing method, sooner or later. There are a few options to do that. The first one is taking a loan in a bank. The second one is finding an investor that would give some funds upon their own conditions. Finally, another method is finding multiple investors that would finance the company, which in exchange would require making the business and financial information of the company public. This is exactly what is called an IPO.
In fact, the company sells a part of it as shares in a stock exchange, and the more investors buy shares, the more funds can be raised. The shareholders will then be able to get dividends, i.e. a fraction of the company’s profit. Not all companies are, however, ready for this: for example, Facebook does not pay dividends, the only source of income for investors being rising share prices. Some companies cannot afford not paying dividends, as it may become less attractive for investment. Apple, on the contrary, pays the highest dividends in the world: in the first half of 2018 shareholders got $13.22 billionin dividends. Facebook will start making dividend payments, too, but obviously when the price is going down and there are no other ways to support it.
Thus, investors have two options to earn money here: with the price going up (to capitalize on this, the company in question must be fast-growing and have very good potential) and with dividends. Ideally, an investor should leverage both options whenever possible.
In order to run an IPO, the company must find an expert who will be able to raise as much funds as possible. Of course, it may act on its own, but in this case chances are that the funds raised will not be even enough to cover the IPO running costs. The professionals that run IPOs are called underwriters, and are usually banks and/or insurance companies.
How Do Underwriters Earn?
Underwriters finance IPOs and get shares at a price that is considerably lower than IPO. This is how they earn. To make more money, underwriters will make every effort for the IPO to be successful and attract as many investors as possible. Many of them run road shows, i.e. ad campaigns for attracting investors.
Road shows include meetings with potential investors and analysts in countries with key financial centers, such as the UK, Germany, the US, or China. Before that, a presentation on the company’s business, financial background, and outlook is created. The company’s management then comes to visit potential investors where they show this presentation. Media and press coverage of the upcoming IPO is also very important, as it helps drive more attention to the company once it get listed on an exchange.
During road shows, large-scale investors can buy shares even before the IPO. Underwriters accept such bids, but often with a high entry only, like a few millions of dollars. If you have just a few dozens of thousands, you are unlikely to be able to buy shares directly from the underwriter. However, there are tricks that may allow you to take part in the IPO even before the latter actually occurs.
As mentioned above, road shows are often covered in media in order to increasedemand. During such campaigns, some intermediary companies form a pool consisting of may lesser bids and send the overall bid to the underwriter. In theory, this works fine, but in practice underwriters seldom answer such bids.
The first thing you need to pay attention to before the company’s IPO is the underwriter: the more famous and trusted it is, the more likely the IPO will be successful.
If the company itself is a promising one, underwriters will be competing for the right to run its IPO, and the company will have a chance to choose from a list of very reputable underwriters, such as Morgan Stanley, Citigroup, or Goldman Sachs. Choosing two or more underwriters at a time is also possible.
The results of the road show determine the share price, and it is quite important not to make this price too high at the start. This very thing happened to Facebook, whose underwriter was Morgan Stanley. Interest in Facebook’s IPO was extremely high, and while the starting price was first set at $17, Morgan Stanley decided to make it higher a few weeks before the event, as well as to increase the number of shares issued (out of mere greed), which then led to the share price falling on IPO day. Overall, Facebooklost 21% during the first week.
After the company finds its underwriter, it also has to determine which exchange to use for the IPO. Again, if its a promising company, the exchanges will be competing for it, too, as more successful public companies mean more liquidity, volume, and commission earnings.
When the exchange is found, too, the very trading process finally starts. On the first trading day, increased volatility is a common thing. In order to maintain high interest towards the IPO, underwriters tend to a bit underrate the shares, so that the price may go up at the moment of the IPO.
During the IPO, insiders, i.e. those early buyers who got shares before they went to the public, may not sell any shares; you can’t earn anything by going short, too, as during the IPO short positions without coverage are forbidden. This way, the traders may either buy shares or do nothing.
The period during which insiders are not allowed to sell shares is called lockup and lasts from 90 to 180 days. The exact time line is determined by the company, and the terms are negotiable. This is all very important for the company, as shortly after the IPO a very low fraction of shares is sold out, while the major stake is held by those who but them before the IPO; if they sell at once, the supply may increase a few times, which could lead to a sharp price decrease and panic among investors.
The lockup is lifted gradually, where the shareholders may start selling their shares in order to stimulate volumes, which leads to temporary falls by 1% or 2%. Lockup dates and time lines are detailed in the S1 online form which is sent to the Securities and Exchange Commission (SEC) every day.
Those who want to capitalize on the IPO on the same day have to pay attention to some factors that will show whether such IPO will be successful. Remember: no short positions during the IPO, so if you want to trade, you will have to buy.
The first thing you must pay attention to, whether you are investing in the short term or in the long term, is the underwriter: the more famous and popular it is, the more likely that shares will go up after the IPO.
The second thing is the percentage of shares offered during the IPO. If it is too large, this may influence the share prices negatively, especially considering that those who bought shares before the IPO will be also selling them at some point. Conversely, small percentage usually makes the price go up, although you should pay attention to a number of factors, not just this one.
Third, there is a price range defined before the IPO: the wider it is, the more in-demand will be the shares once trading starts. Then, you should watch the open price: if it is near the high of the range or goes even beyond, this will show the demand is quite high, and may lead to the price rise both intraday and in the midterm, when the lockup period is over.
However, there are volatility risks, too: when the price opens higher than the pre-defined range, the price rise may last for a very short time, after which the price will return within the range again. After this happens, a good support level may form, which may later be used as an entry point. Conversely, if the price opens lower than the range, this means the demand is low, and the shares may lose even more going forward.
The number of employees is quite important, too. Some IPOs are run with three employees in the company; of course, this is dangerous: they just want to raise funds, and don’t care about what will happen next. This has happened in cryptocurrencies lately, where each one with appropriate skills and equity was able to create their own crypto and start trading it.
IPO Explained: Opera Limited
Opera Limited, the owner of the famous Opera web browser, ran its IPO on June 27, 2018.
- 6M of shares were offered after the IPO, while 60M went to some retail investors before; thus, over 15% of shares went to the market.
- The number of employees in the company exceeds 800 people.
- There were two underwriters: Citigroup and China International Capital Corporation Limited, one of the leading investment firms in China.
- The range was between $10 and $12.
Upon the market opening, the price exceeded the range by nearly 15%, making it $14.33, while at some point it even went to $15.50 and above. This shows investors are highly interested in the company, which is a good signal for long term investmemt. With high volatility pressure, the price went below $12.00, but then got support and went up again.
Currently, Opera shares are trading withing the range set up before the IPO. Once the lockup is over and $12 gets broken out, the price may start uptrending steadily.
In the midterm, there is only one risk for Opera shares: the trade war between the US and China, which may lead to a massive fall in the stock market, and in Opera Limited shares in particular. Many analysts say trade war issue may get escalated this fall, so such risks should be taken into account at once.
Any predictions contained herein are based on the authors’ particular opinion. This analysis shall not be treated as trading advice. RoboMarkets shall not be held liable for the results of the trades arising from relying upon trading recommendations and reviews contained herein.