IPO's Risk or Reward?
“To the extent that the IPO price is a forecast of the secondary market price for the stock, these forecasts are not only biased downward (underpricing), but the range of the forecast (or pricing) errors is huge,” according to The Variability of IPO Initial Returns, Lowry, Officer, and Schwert.
Who doesn't want to get in on the newest, latest, and greatest? Well, we all know about the social media giant, LinkedIn (NASDAQ: LNKD) IPO. And of course, Groupon (NASDAQ: GRPN) visits the mailbox of the multitudes daily. Are you distraught that you missed these IPOs? Don't be.
IPO's are exceedingly difficult to value. There are tremendous pricing errors in these issues. As the above quoted research states, many IPOs are underpriced, but there are also those new issues that are overpriced. How is an investor to know when to dive in on opening day or when to wait?
LinkedIn closed at $94.25 on its opening day. Wednesday, November 30th it closed 30 points lower at $65.93. Was it a fluke?
Let's look at a few more recent IPO's.
- Pandora, IPO close: $17.42, Wednesday's close: $10.18.
- Groupon, IPO close: $26.11, Wednesday's close: $17.50.
If you think these are just coincidences, plug in a few more recent IPO ticker symbols into your browser to find out.
What causes these violent swings in prices? Thin float for one. When there aren't many shares available, there's high demand for few shares causing a bit of a ruckus. Furthermore, it is very difficult to value a newly public firm. The initial pricing data may be lower or higher than the intrinsic value. When there are only a few shares trading, the volatility is enormous.
In fact, if the company is a solid one, waiting a few years for some public revenue, earnings, and operating efficiency metrics to come in will not preclude your participation in the profits. My recommendation, wait on these upcoming startups poised to go public this month, Zynga and Jive Software. If the growth and profitability is sound, there will be sufficient time to invest.
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