Updated on November 3, 2023
IPO or initial public offering. A term that the vast majority of investors will encounter after some time.
Whether you’re a long-term investor or a day trader, you should know what the term actually means.
After all, there is a lot of money to be made in IPO shares. How can you actually find such shares? You will find that and much more in this article.
IPO: What is it?
In order to explain how trading in such shares actually works, let’s first look at what the term means. IPO stands for Initial Public Offering.
This can be translated into English as “Initial Public Offering of Shares”.
It is a situation where a company decides to offer its shares to the public for the first time. This means to any investors who decide to invest in the company, so maybe even you.
There can be several reasons why companies decide to do this. But usually it is for financial reasons, where the company needs support in its plans for its own development.
So if it has one, but doesn’t currently have enough spare cash, it can take several steps. First, you might think of going to a bank and taking a loan. But this is not always the ideal way to go ,mainly because the interest rates can be too high for the entrepreneur.
Another option is to issue bonds. In this case, the company is in the role of a debtor, where the owners of its bonds have to repay the principal and interest within a certain period of time.
The third option is the issue of shares. By virtue of these securities, the company partially relinquishes control of itself to its shareholders. And it also has some obligations to the shareholders that must be met, for example, to pay them a dividend if the company bets on dividend shares.
Preparations for the IPO
If a company decides to opt for this third option, i.e. to issue its own shares to the public, it is usually in for a long haul. The process of preparing for an IPO is not easy, as there are many points to be met. According to the Prague Stock Exchange, the following points are included in this process:
- selection of the issue manager and other members of the implementation team
- selection of the market for the IPO
- Thorough due diligence of the company
- internal valuation of the issuing company
- convening the general meeting
- preparation of the issuance project
- negotiations with the regulated market organiser
- presentation of the company to investors (road show)
- decision on the issue price of the shares and their allocation among investors (pricing)
- admission of shares to trading on the regulated market for investment instruments
In addition to this, it is often necessary to address whether the company meets the requirements for a given stock exchange. This means whether it prepares financial statements according to the IFSR (International Financial Reporting Standards) and whether it has a sufficiently transparent ownership and organisational structure.
If the company does not meet these requirements, it must rectify everything before listing on a stock exchange. Not surprisingly, the process of preparing for an IPO can drag on for several years.
Timing of the IPO
But it is not just the preparation that can delay the IPO. It can also be strategic timing. It is not always the right time to offer shares to investors. Generally, investors are more interested in shares during times of economic growth. Conversely, when the market is down, they lose interest in stocks and prefer to rely on precious metals to preserve value.
So if management finds that the time is not right to go public at the moment, it may mean prolonging the process.
Of course, investors are most interested in the final stages of the project. That is, the period when all formal and legislative steps have been completed. That is, the moment when the listing is officially announced to the public, the preliminary price of the shares is set and the listing of the securities on the stock exchange officially takes place which comes with the sale of the shares to individual investors.
How an IPO can be traded
How can you, as an investor, acquire IPO shares? Basically like any other trading instrument. You can get it from some online brokers. Exante is one of them. You can also use the services of individual investment banks or online investment portals.
As an investor, the first thing you will be interested in is the prospectus. This is an extensive document that the company publishes just before the start of the subscription period. It is intended to acquaint you with the terms of the issue and also with the company itself and its activities.
It should disclose the basic information required by the regulatory authority concerned. So if the company decides to list its shares on the Czech stock exchange, the prospectus will be approved by the CNB (Czech National Bank). For US exchanges, the prospectus will be reviewed by the SEC (US Securities and Exchange Commission).
We must point out, however, that just because a regulator approves a prospectus does not mean that it recommends the securities for investment. It merely indicates that the document meets all the formal requirements. That is to say, it contains everything it should contain. However, the final investment decision rests with the investor.
Let’s be clear about one more concept. This is the subscription period. This means the period during which prospective shareholders can place their orders. Potential investors usually have a week or two to do this.
So if you are interested in IPO shares, you need to open an online form where you fill in the details of your enquiry. You must be careful that you fill out the form correctly in order for your order to be included in the order book. Otherwise your order will be discarded.
However, even if you fill it in correctly, you are not completely out of the woods. Not every applicant for shares is successful. This is the case when the interest in IPO shares exceeds the volume of securities. In the first instance, companies usually give preference to large investors who promise to hold shares for the long term. This ensures a stable price. In general, therefore, IPO shares tend to be less accessible to small individual investors than to larger institutional investors.
If demand outstrips supply, the company may choose to exercise the upside option within 30 days of the IPO date. This allows it to increase the volume of shares by up to 15% over the original plan. However, if investor supply still exceeds the supply of shares, a random draw will decide the allocation of shares. This is why it may happen that the company allocates shares to some investors and not to others.
Specifics of trading IPO shares
Rather than for long-term investors, trading IPO shares is beneficial for short-term traders. This is mainly because of the IPO effect, as well as the underperformance of companies that have freshly offered their shares.
The IPO effect
Short-term traders go into IPO trading mainly because of the IPO effect. This refers to a situation where shortly after a stock is issued, its price rises sharply. This is the right time to sell. Because these traders can make a very good profit on it.
This period doesn’t last long, usually a few hours after the securities are launched on the market.
Why does this happen? This may be because the exchange rate is undervalued. The shares are therefore sold at a lower price than the market will generate during these few hours. Undervaluing the shares is not naturally the aim of the company, which instead tries to raise as much money as possible through the sale. But it must find a value that investors are willing to pay for the share.
But this effort to price the shares correctly may not always succeed. As a result, the market can see shares that are undervalued, overvalued and also those that are correctly valued. However, the goal of investors who intend to capitalize on the IPO effect is to find securities that sell below cost.
Another cause of the IPO effect lies precisely in the activities of short-term traders who sell their IPO shares. They logically try to sell these securities at a higher price and thus make a profit. This, too, increases the price of the shares immediately after they are issued. However, this depends on the demand from other investors.
Reduction in corporate performance
When we observe the regularities of the market, we find that companies that have publicly offered their shares subsequently underperform other companies with similar market capitalizations. And they are not able to increase it even several years after the IPO date.
Typically, this stagnation lasts for 3 to 5 years. The cause may be that the team overvalued the company before the IPO. Alternatively, it may be that the management did not choose the right time to enter the market. As we have already mentioned, it is necessary to find a timing that makes investors interested in the stock. And ideally at a time when the economy is booming.
Is an IPO worth trading?
So the question is – is an IPO stock worth trading? We promised at the outset that there is a nice profit to be made in IPO trading. And we stand by that. The IPO effect we just introduced a moment ago is responsible for that.
So if you choose the right stocks, you can expect to make a nice profit as a short-term trader. Beware, however, not all stocks are necessarily undervalued and then the IPO effect may not happen.
We also recommend not to neglect fundamental analysis when trading IPO stocks. You can take freely available information as well as the prospectus to hand. This is an essential document for investors when they are deciding whether it is a good idea to buy a stock. However, when it comes to technical analysis, it won’t help you much. For one simple reason.
Since this is a newly issued stock, you won’t find any price history. Therefore, assets that have been on the market for some time are more suitable for technical analysis.
However, long-term investors must take into account that they are unlikely to win with IPO stocks. This is mainly due to the phenomenon of companies underperforming for several years after their IPO. Therefore, we recommend that these investors look to stocks of companies that have been on the market for some time.
In addition, you will have the advantage that you can use technical analysis tools.