How To

What to consider before buying into an IPO

By Market Index
Wed 30 Mar 22, 6:45pm (AEDT)

Key Points

  • Avoid overpriced and over-spruiked companies wired to lacklustre sectors with questionable growth projections
  • Any company’s glossy (IPO) prospectus is basically an advertising document, and the brokerage/investment bank underwriting the IPO are salespeople
  • The ASX is littered with examples of floats that didn’t make shareholders' money

A company’s decision to float on the Australian Securities Exchange (ASX) is typically done together with an initial public offering (IPO).

This IPO allows them to raise funds needed to expand the business. That’s great for those responsible for bringing a company to market, but not always great for you.

An IPO can provide a ground-floor opportunity to acquire tomorrow’s ASX leaders before future growth is factored into the price. But the opposite is also true, and based on the ASX’s recent past, you’ve got a 50- 50 chance of an IPO being valued at less than what you paid within the first 12 months.

Watch what you buy

First the history lesson: The ASX is littered with examples of floats that didn’t make shareholders' money, either short term or even over the longer haul. For example, retailer Myer Holdings (ASX: MYR) share price has bounced its way to $0.54 from its $4.10 issue price in October 2009.

More recent examples include Before Pay (ASX: B4P), and Birddog Technologies (ASX: BDT) and CareTeq (ASX: CTQ).

The trick to weeding out quality IPOs from duds is avoiding overpriced and over-spruiked companies wired to lacklustre sectors with questionable growth projections.

For example, many junior and not so junior mining plays are on a tear right now, due to the rise in commodity prices, notably lithium, nickel and those used to make EV batteries.

But don’t be fooled, despite the frenzy around commodities, resource stocks can and do crash and burn, even despite ample funding. For example, 88 Energy (ASX: 88E) shares were down -51% at noon today (30 March 2022) after results from a wireline program fell well-short of expectations. 

What to consider

When considering any IPO, long term is a much better approach than trying to sell immediately after the IPO for a quick profit – aka ‘stagging’.

The trouble with any company’s glossy (IPO) prospectus is that it’s basically an advertising document, and that the brokerage/investment bank underwriting the IPO are salespeople.

Equally important, investors need to remember that there are no philanthropic motives when companies decide to float their stock.

If the [IPO] prospectus doesn’t provide full transparency, you don’t have the information to assess the business and are unable to make an informed decision.

One hoary old chestnut many IPOs used during the pandemic was that due to covid the future was too hard to predict.

Hence, they didn't even try to make prospectus forecasts. Trouble is, many investors fell for this trick and ended buying lemons like Before Pay.

Ideally, you should be attracted to the floats of companies with consistently above-average return on equity (ROE), with little debt and not too much goodwill on the balance sheet.

Clear path to profitability

Guidelines for pressure-testing IPOs with fledging business models include:

  • Understand the business model in the context of its competitive environment.

  • Examine the likelihood of the company generating consistent profits.

  • Investigate the potential future risks to the business.

In short, it’s important to treat IPOs like any other ASX stock, and if there’s no clear path to profitability, don’t buy it.

Is private equity running for the exit?

Always be wary if its private equity that’s selling out during an IPO.

Private equity has had a nasty habit of loading a business up with debt, failing to spend enough on capital expenditure to show low depreciation and high historical earnings figures that aren’t sustainable.

Are you smarter than those selling the business?

When it comes to buying IPOs why not ponder the immortal lines of Warren Buffett, the world’s most successful shareholder, when he quipped:

“It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less knowledgeable buyer”.

If the insiders who know the business backwards are selling, ask yourself why you’d buy from them?

Do this

Investigate previous financial statements of companies planning to float, to find out:

  • If IPO forecasts of future revenue look realistic.

  • Whether the money raised is being earmarked to fund expansion or repay debt - not a good sign.

  • The amount to be paid to existing owners.

Equally important, check insider-selling escrow periods and how many shares are in escrow.

Often the amount is small compared with the initial sale through the IPO, and the escrow period also makes it look like the insiders are heavily invested when they’re not.

Good luck.

Written By

Market Index

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