Is your client excited about new IPO stocks hitting the market like Robinhood (HOOD), but you’re unsure how to approach the conversation? Considering the fanfare around major IPOs, they can be hard to ignore — but it isn’t always easy to decide whether to invest in one or not.
While the potential to win big on a new stock may be alluring to a client, there are some key considerations to make before investing.
An IPO, or Initial Public Offering, is a company’s first stock offering to public investors. It’s also the first opportunity for most of the market to dig into the company’s financials. As such, limited information about new IPO stocks can cause the market to feel it is mispriced, and lead to dramatic swings in the share price.
However, new ways of going public have gained in popularity. Several companies have recently gone straight to the exchange via direct listing or SPAC, opting to bypass institutional banks and underwriters that typically handle IPOs, along with the hefty fees they charge. Then, there’s the case of Robinhood, whose IPO blended elements of both the traditional and direct listing methods, completely shaking up how initial offerings are conducted. Many directly-listed IPOs saw success early on in their publicly-traded lives, especially Robinhood.
With the IPO market seemingly being disrupted, it’s important to educate yourself on recent developments so clients may be properly informed as well.
Boom, or Bust?
IPO stocks can “boom”, soaring high above their initial offering price, or “bust”, and lose a significant portion of their value shortly after going public. As an example, the chart below compares the growth of a $10,000 investment in both Blue Apron (APRN) and Roku (ROKU) in the four years following their IPO dates (June & September 2017, respectively). While investors in Roku’s stock could have grown their initial investment by over 15x, the same cannot be said for those who bought Blue Apron stock and held are down 95% as of August 2021.
Even when looking at new IPO stocks more broadly, there is a trend of underperformance versus the market as of late. Our previous analysis showed that only 38% of the largest IPOs between 2009 and 2018 showed better annualized returns over the period than the S&P 500.
A good proxy for overall IPO performance is the Renaissance IPO ETF (IPO), which tracks an index of recent IPOs on U.S. stock exchanges. While new IPO stocks may have underperformed over the past decade or so, that trend might be reversing. The chart below shows the Renaissance IPO ETF outperforming the broader market since April 2020, and it has returned more than double the S&P 500’s total return as of August 2021.
Investing in New IPO Stocks
If your client is interested in a new stock, they should first understand a few key facts about IPOs, and the most important metrics for analyzing them. It’s crucial to understand how IPOs are priced and the different ways they come to the market:
• The traditional method involving underwriters and investment banks
• Direct listing and SPACs, which have become more popular in recent months
• Robinhood’s unique method, which blends traditional underwriting with direct listing
Underwriting: The Traditional Way of Pricing an IPO
Before listing on a public exchange, companies first go on a “roadshow” and market their shares privately to large institutional investors. The goal of a roadshow is to generate demand for the new stock from the investment community. After the roadshow is completed, the IPO price is set based on investor demand.
While everyone who buys a new IPO stock is interested in a “pop” — when a new stock’s price surges on its first day of trading — institutions that subscribed during the roadshow stand to gain the most. It can be harder for ordinary investors to take advantage of a potential pop because prices adjust very quickly once public markets get access to IPO shares.
For that reason, purchasing a new IPO stock at its offering price can be difficult—something Robinhood is trying to change, and we’ll explain how shortly. If your client is interested in buying right away, inform them that they may miss the short window in which they can get an attractive price on their trade. Conversely, the price could decrease below the offering range on the first day of trading, and lose a lot of value in a short time.
Finally, be wary of the “lock up period.” The SEC prevents insiders (usually employees and early investors) from selling shares during the first 90 days of trading. Once the lock up period ends, selling pressure from insiders can lead to a sharp drop in the stock price. While this price drop may not be caused by any fundamental shift in the company’s outlook, you and your clients should be aware of its potential impacts.
Investing in Direct Listings & SPACs
In the last few years, several stocks have gone public through Direct Listings. Your clients may have asked about the Coinbase (COIN) or Spot (SPOT) direct listings, and what the difference between a traditional IPO and direct listing really is. Also known as a Direct Public Offering or Direct Placement, a direct listing is when a private company offers their shares directly on a stock exchange, bypassing the traditional underwriters and roadshow. A company may choose a direct listing over an IPO if they are confident there is already enough demand for their stock from the public, or if they wish to avoid a lockup period.
For investors, the key differentiators of a direct listing versus an IPO is less guaranteed demand for shares and earlier opportunities for company insiders to sell shares. Both can impact a new IPO stock’s share price, especially in the near-term.
Recently, SPACs have become a hot topic. Special Purpose Acquisition Companies (SPACs) are shell companies that go public for the sole purpose of later acquiring a private company. SPACs can help streamline the IPO process for private companies, and often pay higher share prices to the company than an IPO would. After the SPAC acquires a private company, it will assume that company’s identity, and shares will be traded publicly as such.
Read more about SPACs here, find current public SPACs within the shell companies subsector on YCharts, and use the SPAC Units dataset to evaluate pre-merger SPACs. Want to learn more about SPACs? Download our free white paper that examines SPAC performance pre and post merger.
Investors face additional risk when buying shares in SPACs, in that no one knows what company the SPAC will acquire. Essentially, shareholders are investing their money in the SPAC management team’s ability to find and acquire a quality company.
Robinhood: The Road (to the NASDAQ) Less Traveled
Then, there’s Robinhood. The zero-commission, everyday investing platform more infamously known for trading #YOLO options, so-called meme stocks such as GameStop (GME) and AMC Entertainment (AMC) as well as Dogecoin and other cryptocurrencies went public on July 29th, 2021. Robinhood opted for the traditional IPO route, tapping Goldman Sachs and J.P. Morgan to underwrite the initial offering, but also stuck to its retail roots by directly offering 35% of IPO shares to its 22.5 million users.
Before its own IPO, Robinhood had already unveiled an “IPO Access” feature for its users to invest in upcoming IPOs. This gave users the chance to be at the front of the line alongside large institutional investors for shares of Clear Secure (YOU) and Duolingo (DUOL), to name a couple of recent listings. Democratizing IPO access seems to be a trend picking up elsewhere—SoFI Technologies and Public Holdings are soon launching their own platforms for retail investors to access IPOs.
What makes Robinhood’s IPO especially eye-catching, however, is not just the company’s first and one-of-a-kind “IPO Access” feature. Robinhood’s business as a brokerage firm lets it do something unique with this IPO: offer shares of its own stock on its own platform. Essentially, Robinhood lets users buy Robinhood…on Robinhood. It appears those users—and possibly others—have been following that mantra in HOOD’s infancy.
Key Metrics for Evaluating New IPO Stocks
As part of the IPO process, companies release their historical financial statements and other information to the SEC and the public. Below are key metrics and estimates to evaluate a new stock on the market:
Quarterly & Annual Revenue Estimates: Wall Street analysts’ expectations of future company sales. Strong top line revenue growth is important for newer companies; look for estimates that are higher than past period’s figures.
Quarterly & Annual Earnings Per Share (EPS) Estimates: Wall Street analysts’ expectations of future earnings-per-share. EPS estimates project the company’s profits relative to the number of shares outstanding, and they’re one of the most-cited metrics when determining a firm’s value. Upon a company’s quarterly earnings release, “beating” or “missing” estimates can swing the share price.
Price to Sales (P/S) Ratio: the current share price divided by revenue per share. P/S ratios are best used to compare companies within the same industry, as profit margins can vary significantly across industries. Relatively lower P/S ratios mean stock is undervalued based on its revenue, while higher P/S ratios may mean the stock’s price is inflated. Keep in mind, future expectations for higher revenue may be “priced into” a new stock’s price.
Enterprise Value to Revenues (EV/Revenues): the current value of the firm relative to its sales. A higher EV/Revenues ratio means a company may be overvalued, and vice-versa.
New stocks on the market have limited trading histories; for those that have been on the market a little longer, there are some other metrics and estimates to evaluate the stock’s potential for growth:
Price to Earnings Growth (PEG Ratio): the company’s P/E ratio divided by its growth rate. The PEG ratio allows investors to compare companies across industries with different P/E ratios and growth rates; a PEG ratio equal to 1 is considered fair-valued, while lower than 1 is undervalued for its growth rate, and higher than 1 is overvalued.
Forward Price to Earnings (P/E) Ratio: the current share price divided by Wall Street analysts’ predicted earnings per share. If a company’s Forward P/E Ratio is lower than its current P/E ratio, earnings are expected to increase.
Should You Invest in An Upcoming IPO?
New IPO stocks can be risky. Newly listed companies lack the historical performance metrics and track record of more established firms. If your client is interested in a new stock, here are few things to consider:
What is your client’s risk appetite? Are they more risk-averse and uncomfortable with large losses, or do they have a higher tolerance? Your client’s risk profile is the main determinant of whether investing in new IPO stocks is suitable for them.
What is your client’s portfolio composition? An IPO stock may require more frequent monitoring and evaluation — determine if the additional due diligence is consistent with the size and composition of a client’s portfolio.
Have you considered dollar-cost-averaging? By slowly accumulating shares, you can avoid the risk of mistiming an investment, mitigate some potential volatility, and build your client’s position over time.
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