Protecting Against Losses in Choosing IPOs
If you are interested in buying an IPO, you should investigate the
company before you buy to limit your risk of loss. Although paying
attention to a prospectus does not ensure success, it certainly is a
good defensive measure.
Check the prospectus for the following:
* The underwriters. Is the underwriting company well known?
Large, well-known underwriting firms generally are busy
enough to screen out the more speculative IPOs. Even so,
some new issues of immature companies are still underwritten
by top underwriters, and the stock prices have
fallen into oblivion after being brought to the market. Check
the underwriter’s record by asking the broker for a list of
recent underwritings or by checking on the Internet at
* The number of underwriters in the syndicate. Large syndicate
groups generally give an IPO more exposure. Additionally,
large syndicates provide more brokerage firms to trade the
new stock, supporting its price (Barker, 1997, pp 168–169).
* Financial statements. Look at the financial statements in the
back of the prospectus. From the balance sheet, determine
who has provided the capital for the assets. Is it primarily
from debt or equity? If total liabilities exceed shareholders’
equity, this is a red flag and requires further investigation. If
the company has a downturn in revenues, can it still service
its debt? If the shareholders’ equity is negative, look carefully
at the financial details of the company. Companies that
have posted losses that exceed the amount of their retained
earnings have negative retained earnings. If these negative
retained earnings exceed the amounts in the capital
accounts, the company has a negative shareholders’ equity.
Determine whether this company has the ability to turn its
losses into profits in the not too distant future to maintain its
business. Lazard company had sizable debt and negative
book value, explaining its lackluster share price performance
Related to the income and losses is the cash flow a company
generates. For example, Friendly Ice Cream, the
restaurant chain, chalked up losses from operations since
1992, but this company had positive cash flows (Barker,
1997, p. 169). You can calculate whether cash flow is positive
by starting with net income or loss and adding back the
noncash items such as depreciation and amortization.
From the income statement, determine whether sales and
earnings are growing. If a company experiences growth in
sales but shows a loss in income, examine its prospectus for
comments about profits in the foreseeable future. If profits
are not anticipated soon, another red flag is raised. Anote of
irony: If investors had listened to this advice, they would
never have bought any of the new Internet IPOs in October
and November 1998, whose share prices mostly went up in
the same trajectory as a rocket taking off for Mars. Most of
these companies did not anticipate having earnings for
years to come and were trading at rich multiples of sales.
You should not assume that every company with an idea
and no earnings will always be successful, however.
* Discussion and analysis by management. See if there is any
cushioning of future trouble signs ahead. Take a step back
and ask: what could go wrong with this company? What are
its risks? Who are its competitors? Who are its customers?
Assess the overall risks of the company. If it is too risky,
walk away from it.
These precautions can help you to limit the risk of loss from
investing in IPOs.
New Issues of Securities
New issues of securities occur whenever exchange-listed companies
want to raise new capital by issuing more securities. The procedure
for issuing new securities to the public is roughly the same
as with an IPO. Before securities are sold to the public, they must be
registered with and approved by the SEC. The prospectus, called
a shelf registration, is less detailed than that for an IPO because
the company has already filed the necessary reports with the SEC,
in addition to quarterly and annual statements and the necessary
initial reports. The price of the issue approximates the market price
of the company’s securities, and less fine-tuning of that point takes
place between the investment bankers and the company.
Categories in Trading Mistakes
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Failure to control Risk
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Lack of Discipline
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