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$2.5 million. That’s how much a $10,000 investment in Microsoft (MSFT) initial public offering (IPO) would be worth today. If Paris Hilton knew what an IPO is, she would say “That’s hot.” We all dream of owning that one hot stock that will transform us from a lowly wage earner to a philanthropist. But are IPOs worth betting our life savings on?

Before we get ahead of ourselves, let’s look at why a business wants to go public. A company could sell its stock to the public for various reasons including raising capital to fund future growth, providing seed investors a means to cash out, and increasing liquidity to avoid bankruptcy. Clearly, a company raising capital to avoid bankruptcy may not be a good candidate for an IPO investor. So it is important for IPO investors to understand the motive behind the public offering. Ideally, the funds from financing should be used to increase the intrinsic value (the sum of the present value of all future cash flows) of the business.

Even though the intentions of the company may be good, it pays to understand a little about the motivation of the parties involved in an IPO. There are four roles involved in an IPO:

Issuer
The issuer is the company that wants to sell its stock to the public. The company will receive the majority of the cash from the IPO after fees and commissions.

Underwriter
The underwriter is responsible for pricing and allocation of the shares to brokers. This role is usually played by investment bankers such as Goldman Sachs, Merrill Lynch and JP Morgan. Underwriters stand to earn up to 8% in fees from IPOs.

Broker
The brokers sell shares to investors or buyers. An affiliate of the underwriter usually also participates in this role. A broker earns between 15% and 30% in commissions.

Buyer
Buyers are mostly made up of institutional investors and high-net-worth investors. A very lucky few retail investors may get their hands on limited IPO shares.

Looking at the four roles, perhaps you can’t help but notice that the selling camp comprising of the issuer, underwriter and broker is a lot bigger than the buying camp. The issuer, underwriter and broker all stand to profit from the IPO regardless of how the company performs in the long term, except for the buyer. To launch a successful IPO, the issuer will work closely with the underwriter to price the shares to the advantage of both parties. A higher price translates to more cash for the company and fatter commission for the underwriter. It is only logical that the underwriter almost always plans to launch the IPO when the industry the company operates in is at its peak. The unscrupulous issuer might even exercise finance engineering to spruce up the company financials.

When pricing the new issues or shares, the underwriter usually prices it at a slight discount to its value depending on the market demand. This allows the underwriter to build a premium (usually 15%) into the opening trading price to entice buyers. In other words, average retail investors who hope to get in on the action are always paying at least full price for the shares the day the stock begins public trading. Always.

The broker of course has no motivation to look out for the buyer’s interests considering the broker earns the commissions no matter how well the stock performs. Furthermore, the broker earns a much lower commission in the secondary market, which is where investors resell the shares to other investors.

With these three roles on the selling side working against the IPO investor, how good can the deal be for the investor?

Dr. Yochanan Shachmurove wrote in a paper^[1]:

This paper investigates the actual performance of 2,895 Initial Public Offerings of companies that were backed by venture capital from 1968 until September 1998. In this paper we find that it is incorrect to assume that investors demand very high annualized and cumulative rates of return to compensate for the risks they are taking by financing ventures in different sectors of the economy. The mean rates of return are found to be, in practice, very moderate, and often, negative.

Despite the above arguments against investing in IPOs, not all IPOs are lousy investments. The problem is not many investors have the stomach to stick to their guns and wait for the stock to recover having lost 75% of its value two weeks after IPO. So they sell, not knowing had they held on to the stock they would have been millionaires in 20 years. One such example, Coca-Cola (KO), traded at $40 at IPO and plummeted to $19 the following year. Today, that share is worth over $5 million^[2].

Investing in IPOs may be a bad idea. But investing in the business several years post IPO may be the best idea you’ll ever find in your lifetime.

References

1. The Reality of IPO Performance: An Empirical Study of Venture-Backed Public Companies (PDF), Dr. Yochanan Shachmurove
2. Should You Invest in an IPO?, Joshua Kennon, About.com

Side note: My recent post Investing Mistakes - 5 Deadly Sins of Investing was featured on the 104th Festival of Stocks and the 10th Investing Carnival. Both carnivals offer some wonderful advice on investing.