When Jack Ma sold shares in his private Chinese e-commerce company Alibaba in the world’s biggest initial public offering last year, he pushed his own net worth to US$16 billion and put US$300 million in fees into the coffers of his bankers and brokers.
It is often the case that the people selling the company, and their brokers and bankers do well. But what about the investors? How do you know when stock you’re about to trade for the first time is well-priced?
Alibaba surged more than 35 percent on its first day of trade, despite being the most well-watched and surely one of the most closely-valued companies to start trading publicly in recent history. Alibaba produced a great stag trade. The seller, the brokers and the new investors all came up trumps. And while for every strong IPO there are just as many that don’t take off in the same manner, the debut listing of a stock is a time you can buy into a company “on the ground floor” as a long-term investment.
There is a science behind valuing IPOs. Investors often look at balance sheet, revenues and profitability. A commonly used measure is price to earnings (PE) ratio. Using this method, investors will look at a company’s projected earnings for the first year – or more if available – to calculate what a reasonable stock price should be compared to its per-share earnings.
What an investor views as reasonable might be based on what comparable stocks are trading at, or more generally-speaking, what either the relevant index – or even the entire stock market – is trading at. If the IPO is being priced at or below the relevant index or comparable companies, then some may view it as a buying opportunity.
Yet another factor in valuing IPOs is potential dividend distributions. Some companies are attractive to investors because they are expected to produce a steady flow of dividends, such as income-producing toll roads (as opposed to greenfield developments) or rail operators.
PE ratios and future dividend distributions don’t always work as a valuation method. Twitter is a case in point. Like many in the hot US technology sector, Twitter was yet to make a profit when it priced at US$26 per share when it sold to the public in 2013.
Investors can be betting on other factors, such as the likelihood of the company eventually having huge earnings because of advancements in its field of expertise, or potentially being acquired by another company.
Valuations on these types of stocks is more difficult because market sentiment plays a bigger role. Certain industries can be “hot” or not; the marketability of a company will play into the valuation of many IPOs. Investors in “hot” stocks need to be aware that this factor may not play into the ongoing value of a company once it is publicly traded.
Apart from the prospect of a company being taken over, other types of factors investors could take into consideration include the prospect of regulatory changes, trade agreements, or commodity or currency fluctuations.
So what happens when you have done your valuations and want to be involved? The issue of who can buy, and how much, then comes into play.
Rules differ from country to country and IPO to IPO, but generally speaking in Australia, shares in the company will first be offered to the brokers at institutional investors – for example fund managers and superannuation firms – at a certain price range.
Demand from those investors will determine whether the shares are priced at the upper or lower end of the range, this period of pricing is called a book-build. A fixed portion of the shares (a significantly smaller amount than offered to institutional investors) will then be offered to retail (non-professional) investors. Their shares are often priced at a fixed percentage rate lower than the price agreed by professional investors.
Sometimes the amount of shares any retail investor can buy will be set at a fixed number, and sometimes, certain retail investors, such as those who are already customers of either the brokerage selling the company, or the company itself, will get the first chance to buy shares.