As a busy executive, you probably have heard many IPO pitches. Many colleagues, wealth managers, and investment banking professionals have perhaps tried to sell you “the next big thing.” Maybe you have gotten into a few and overlooked others.
IPOs can offer a chance to buy a quality stock at a good price. But the key question is whether the company has strong fundamentals or is driven by marketing hype. Even then, another question remains: is the IPO price a good entry point, or is it better to wait for a lower price?
These are good questions, but you may not have time to deep-dive into hundreds of pages of a prospectus to answer them. In this article, we’ll show you how to evaluate an IPO in under an hour by focusing on what matters most.
Focus on four sections in the prospectus
Though every part of the prospectus is meaningful, 4 sections deserve careful scrutiny when learning how to invest in an IPO:
Business model and revenue: The most important fundamental of a company is how it makes money and whether it can keep making money into the foreseeable future (sustainability).
Use your knowledge of macroeconomic conditions, technology trends, and the dynamics of the specific industry to evaluate if the business model is likely to be sustainable.
Financial performance: Focus on four things: revenue, profitability, cash flow, and debt. Is revenue growing? Is the business profitable, or is it at least on a viable path towards profitability? Is it building enough free cash flow to finance growth and stay afloat in difficult economic conditions? Has growth been funded internally or from external debt?
Use of funds: The prospectus will have a section detailing how the IPO funds will be used. The three most common uses are repaying debt, funding expansion, and supporting existing shareholders who want to sell some of their stakes.
The best-case scenario is when the IPO is funding viable business expansion.
Risk factors: The company must also disclose the risks that it faces. This is one reason prospectuses matter more than marketing materials. Some common risk factors include customer concentration, regulatory exposure, supplier dependence, intense competition, and a concentrated product or service portfolio.
The goal is to identify the factors most likely to affect future profitability.
Evaluate whether the IPO valuation is fair
A quality company may be offered at a bad price. In other words, it can be overvalued at the IPO price.
A quick way to know this is to compare its price-to-earnings (P/E) ratio with comparable companies. P/E ratios are commonly available on platforms like Yahoo Finance, Google Finance, and Stock Analysis, among others.
Comparable companies are public companies with similar business models, growth rates, profit margins, balance sheets, and risk profiles.
The IPO price may be too high if the company has a higher P/E ratio than its peers without a sufficient premium on its future earnings growth rate. On the other hand, it may be undervalued if it has a lower P/E ratio even with a comparable or higher future earnings growth rate.
If the IPO company is still loss-making, you can use the price-to-sales or enterprise value-to-revenue valuation metrics.
Decide if and when to buy
If the company has strong fundamentals and is undervalued or fairly valued, you can do further research and invest in its IPO.
If fundamentals are strong but it’s overvalued, it’s better to wait for a more opportune time. As anyone learning how to day trade understands, it’s better to wait for the price to come to you rather than chase it.
After the IPO, the price will fluctuate as buyers and sellers compete. If you are too busy to read candlestick chart patterns and indicators, set an alert for your target price and wait for the stock to reach it before getting in.
What if the company is not fundamentally sound enough for you? There is no harm in saying no to an IPO. There’ll always be another opportunity. And if you change your mind later, you can always buy in the secondary market.
IPOs can be attractive investment opportunities, but you must look beyond marketing hype to determine if the stock is worth buying. The objective is not to buy every IPO but only those where a quality company is selling at a good price.
