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What is an initial public offering (IPO)?
IPOs offer investors the opportunity to buy shares in a newly listed company. Here's how they work.
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We’ll take you through what an IPO is and how it works in this guide, as well as the advantages and risks of buying shares in a company that has just gone public.
What is an IPO?
IPO stands for initial public offering and refers to the event where a company offers investors the chance to invest in the company for the first time. This happens when a private company decides to go public and list on an exchange. For example, if a private Canadian company decides to list publicly on the TSX they’d hold an IPO to offer shares in their company to investors.
Can anyone take part in an IPO?
It’s difficult for everyday retail investors to take part in an IPO, particularly if it’s a well-known company such as Uber. Because the company only has a limited amount of stock to offer, the shares available through IPOs are often reserved for large institutional investors (like other businesses or investment banks) and high-net-worth investors (those with large portfolios and annual income over a few hundred thousand dollars).
Retail investors might get access to an IPO if the demand for the IPO has been lower than expected. You’ll need to be signed up with an online broker in order to get invited to take part in the IPO. If your broker is offered a portion of the company’s shares to sell to clients, the broker will send out the application form for investors to complete. Usually, you’ll need to commit to buying over a certain amount of shares and the timeframe to submit your application to take part in the IPO will often be fairly tight.
However, if you can’t access shares via the IPO it doesn’t mean you can’t invest in the company. When the IPO is over and the shares are officially trading on a public exchange, anyone with a share trading account can buy the shares.
Why do companies hold an IPO?
The main reason a private company will hold an IPO is to raise money. This money can be used to help the business expand into different markets, launch new products, hire a lot more staff, take the business overseas or invest in new infrastructure or technology systems, amongst other things.
If the company needs to raise money but doesn’t want to list on a public exchange, they’d need to source some private funding. Private funding can come from other companies and investment managers, or high-net-worth individuals directly.
How are IPO share prices set?
When a company decides to go public, it hires an investment bank to help it achieve this via an IPO. This investment bank is known as the underwriter of the IPO. The underwriter will basically buy the shares that the company wishes to sell and then resell these shares to their clients. This is why retail investors don’t often get access to shares offered through an IPO: the investment bank will offer the shares to its VIP clients first which will largely include institutional investors and wealthy, high-net-worth customers.
The underwriter will also help the company determine an appropriate price for its shares. IPOs offer a predetermined number of shares to investors at a set price per share. This is different to shares that trade on an exchange already, as the prices of these shares change constantly throughout the day and are influenced by a range of market factors as well as supply and demand.
When a company decides to list its shares publicly on an exchange via an IPO, a lot of work goes on behind the scenes to determine a fair price for the shares. The value of the company will be calculated, taking into account the current value as well as the potential future earnings the company is expected to make over the coming years. Then, it will divide this by the number of shares it plans to issue for sale to come up with a fair price per share for the IPO.
IPO share prices are not always accurate
There’s no guarantee that the share price offered through an IPO represents fair value for that company’s shares. Some IPOs for popular brands can create a lot of excitement, but this doesn’t mean it’s necessarily a good idea to take part in the IPO and buy shares.
Sometimes, if the share price isn’t a fair representation of the value of the company, it will fall below the initial offer price immediately after the company is listed on the exchange, meaning retail investors who couldn’t buy through the IPO could get the shares for a lower price than those who did buy through the IPO. Of course, sometimes the opposite is true and the share price will rise straight after the company goes public, driven in part by market hype.
Should you invest in an IPO?
As we said earlier in this guide, it’s difficult for retail investors with small portfolios to take part in an IPO. If you’re a high-net-worth investor or do find yourself presented with an opportunity to buy shares via an IPO, it’s important to understand the benefits as well as the risks involved.
Benefits of investing in an IPO
- Fixed share price. Unlike regular shares, IPOs offer a predetermined fixed price per share that will not change until the IPO is over. You can take your time researching the investment opportunity and know that the share price won’t change while you’re deciding.
- Get in early. Investing in an IPO gives you the opportunity to be among the first to buy shares in a company, before it’s listed on the exchange.
- Invest in popular brands. IPOs give you the chance to invest in brands that were not previously available as investments.
- Sell your shares for profit. Well-known brands can see their share price rise quite significantly once they’re officially listed on a public exchange, due to hype and excitement among investors. If you’re able to buy shares at a set price through the IPO, you might be able to sell these shortly after the company is officially listed for a profit. This is a high-risk strategy.
Risks of investing in an IPO
- The share price could be overvalued. The set share price offered through an IPO might not be fair value, and you could end up paying more for the shares than they’re worth. If the market thinks the shares are worth less than they’re priced, the share price will fall after the company goes public meaning you could lose money to begin with.
- New companies are often higher-risk. A lot of IPOs are held by newer companies that have only been operating for a few years or even less. Because they’re often still in their growth phase, they are likely to be higher-risk and more volatile than other shares. However, they also offer the potential for strong capital growth too.
How can retail investors take advantage of IPOs?
If you miss out on an IPO, don’t fret! When the IPO is over and the shares are publicly listed on the market, anyone can buy them. Find out what date the shares will be available on the exchange and do your research to determine what price you’re willing to pay for them.
Typically, the share price will be very volatile in the first few days after they’re publicly available following the IPO, as the price is largely driven by supply and demand. It could be worth waiting a few days for the dust to settle before you decide to buy, especially if it’s a well-known company that has created a lot of hype.
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