IPOs are one of the most important things to happen to a company: It’s the first time that they get on the public market. But what does that mean and should you invest in such a newly public company? How does inflation affect this and why do companies go public in the first place?
What is an IPO
IPO stands for Initial Public Offering, which is fairly self-explanatory. Just to clarify, though: Initial means for the first time, public means, in this context, everyone and offering means the offering of shares of a company. When a company goes public, they offer shares to every investor and typically do it at a reasonable price (that is to say, cheap compared with huge chunks of the company, not compared to the market or the firms fundamental data).
But what happens before a company goes public in the first place?
Well, first, the firm works with an investment banker to raise capital. This capital is provided from big investors or institutions and, most notably, venture capitalists who believe that the firm is worth investing in, so that they can get a big chunk of shares before the company grows and therefore profit from its growth. The investment banker manages and underwrites the IPO to get it out on the market. Next, the firm has to sign an agreement with the SEC (Securities and Exchange Commission) to make sure that the company is eligible for trading on public markets. Finally, a prospectus is created which summarises the information about and financial health of the company. The purpose of this document is to generate interest in the firm. This is where the aforementioned venture capitalists even find firms like these. The IPO assesses the interest in the firm and comes up with a price with which the IPO will trade on the market.
Problems with IPOs
All of the above sounds pretty good – for the company. After all, the whole reason that firms even go public with an IPO is to raise money. So, naturally, they will hype up the stock a lot to drive up its interest and justify setting a high IPO price. Remember, when buying shares in an IPO, one is buying shares on the primary market, which is the market in which the firm trades assets directly to investors before they enter the secondary market, which is where trading between individual investors takes place. The firm will want the trades to work best for them. This is why a lot of investors refrain from buying IPOs, simply from a value perspective: It’s too expensive. It’s not like one has a history of prices to follow from the company: It’s brand new! But what if one were to do a “relative valuation”, or, compare the IPO to its peer firms? Well, that’s another problem with IPOs: they mostly take place near peaks of bull markets. The most IPOs take place during these times, because the price of the market is inflated anyway, justifying their pricing. It also means investors are currently buying like crazy. Next: The hype. When investors buy into such large firms, they usually not only view it as an opportunity for immense growth, but an opportunity to be part of something “big”. Many think that when they’re investing into a new tech IPO, they’re really investing into the next Apple or Microsoft. At least that’s what many hope. And while that sometimes does happen… it happens rarely. Once IPOs release, they don’t have much room to grow. Inflated prices combined with an inflated market and a lot of hype, means that once the “big players”, will sell out soon, or, at least, to a degree. And if you’re thinking of buying an IPO, good luck. Brokers will only sell it to big institutions or investors who want to get their hands on the new stock in the first few days.
The value perspective
So, how should one treat IPOs? Value investors often view them as an opportunity. Many of them believe that many IPOs try to get the best price during the peak of a bull market. And what comes after a peak? Oftentimes, a crash, since, inevitably, nothing can grow forever. If they then deem the business to be fundamentally profitable – that is to say, the business is inherently bound to grow – they will buy shares of a company after the crash.
That sounds pretty good: Wait the hype out and when the market has finally come to its senses: Buy. But, what about now? Is it justifiable to buy an IPO in inflation?
IPOs in the pandemic
Before 2020, we were in a very long Bull market. After the financial crisis in 2008, markets have kept rising – until the pandemic hit. This is by some people’s standards a “crash”, but if it is truly one, then here’s the question: If 2020 was a crash year, how come it was one of the biggest years for IPOs? That’s right, in 2020, we were in what some call an IPO rush. This was due to the pandemic putting strain on businesses and governments worldwide being forced to step in. This also included stimulating the economy by lending loads of money, which is terrific for stocks, since corporate bonds are bought more and firms will have easier access to money. This extremely liquid market made a lot of people willing to take a chance and invest into newer start-ups. These start-ups took notice, and what followed was a wave of IPOs.
IPOs and inflation
In 2021 the wave of IPOs… continued to grow! Massively, in fact. This was a carryover from the last year and inflation hadn’t left its mark in the economy yet. It has now, though. With the Fed announcing a battle against inflation by raising interest rates, the question is: Will the number of IPOs continue to grow? The answer is a likely no, since the help that firms have been getting by governments is slowing down rapidly. The governments of the world are no longer investing into everything they can get their hands on for the sole purpose of stimulating the economy. Quantity is not the defining factor anymore – quality is. But what about the crash? A record number of IPOs typically happens before a crash, right? While that is somewhat true, the economic environment that we are now in is fairly new. For now, the economy remains stable and while the battle against inflation is putting strain on firms, we’re getting closer to defeating the coronavirus and the pandemic. Surely, that has to be good for businesses. When the pandemic more or less passes and inflation comes to an end at a similar time, we’ll be in a similar place to where we were before the pandemic, with the key difference that governments will put a lot more thought into asset-purchasing programs. While the market is somewhat inflated anyway – that doesn’t immediately imply that there will be a crash soon. Don’t get me wrong, it will definitely come someday, but the record number of IPOs was produced artificially and we already had an artificially produced crash (the 2020 “crash”), so don’t read too much into those events and treat the economy as a continuation of 2019, with increased scrutiny from governments.
Conclusion
IPOs are mostly a way for rich investors to sell their firm to other institutions or big investors to raise money. From a value perspective, one should wait out the hype before considering a purchase. The 2020 / 2021 surges in IPOs were an artificial result of the pandemic and of an extremely stimulated economy. Don’t read all too much into it because the “real” crash will likely have different origins.
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