How to Discuss New IPO Stocks with Clients
Is your client excited about new IPO stocks hitting the market, but you’re unsure about adding them to their portfolio? Considering the fanfare around major IPOs, they can be hard to ignore — but it isn’t always easy to decide whether to invest in one or not.
While the potential to win big on a new stock may be alluring to a client, there are some key considerations to make before investing.
An IPO, or Initial Public Offering, is a company’s first stock offering to public investors. It’s also the first opportunity for most of the market to dig into the company’s financials. As such, limited information about new IPO stocks can cause the market to feel it is mispriced, and lead to dramatic swings in the share price.
Boom, or Bust?
IPO stocks can “boom”, and soar high above their initial offering price, or “bust”, and lose a significant portion of their value shortly after going public. As an example, the chart below compares the growth of a $10,000 investment in both Blue Apron (APRN) and Roku (ROKU) in the three years following their IPO dates (June & September 2017, respectively). While investors in Roku’s stock could have grown their initial investment by over 800%, the same cannot be said for those who bought Blue Apron stock around its IPO date.
Even when looking at new IPO stocks more broadly, there is a trend of underperformance versus the market. Our previous analysis showed that only 38% of the largest IPOs between 2009 and 2018 showed better annualized returns over the period than the S&P 500.
A good proxy for overall IPO performance is the Renaissance IPO ETF (IPO), which tracks an index of recent IPOs on U.S. stock exchanges. While new IPO stocks may have underperformed over the past decade or so, that trend may be reversing. The chart below shows the Renaissance IPO ETF outperforming the broader market through the first three quarters of 2020.
Investing in New IPO Stocks
If your client is interested in a new stock, they should first understand a few key facts about IPO stocks, and the most important metrics for analyzing them. It’s crucial to understand how IPOs are priced and come to the market.
Pricing of New IPO Stocks
Before listing on a public exchange, companies first go on a “roadshow” and market their shares privately to large institutional investors. The goal of a roadshow is to generate demand for the new stock from the investment community. After the roadshow is completed, the IPO price is set based on investor demand.
While everyone who buys a new IPO stock is interested in a “pop” — when a new stock’s price surges on its first day of trading — institutions that subscribed during the roadshow stand to gain the most. It can be harder for ordinary investors to take advantage of a potential pop because prices adjust very quickly once public markets get access to IPO shares.
For that reason, purchasing a new IPO stock at its offering price can be difficult. If your client is interested in buying right away, inform them that they may miss the short window in which they can get an attractive price on their trade. Conversely, the price could decrease below the offering range on the first day of trading, and lose a lot of value in a short time.
Finally, be wary of the “lock up period.” The SEC prevents insiders (usually employees and early investors) from selling shares during the first 90 days of trading. Once the lock up period ends, selling pressure from insiders can lead to a sharp drop in the stock price. While this price drop may not be caused by any fundamental shift in the company’s outlook, you and your clients should be aware of its potential impacts.
Key Metrics for Evaluating New IPO Stocks
As part of the IPO process, companies release their historical financial statements and other information to the SEC and the public. Below are key metrics and estimates to evaluate a new stock on the market:
Quarterly & Annual Revenue Estimates: Wall Street analysts’ expectations of future company sales. Strong top line revenue growth is important for newer companies; look for estimates that are higher than past period’s figures.
Quarterly & Annual Earnings Per Share (EPS) Estimates: Wall Street analysts’ expectations of future earnings-per-share. EPS estimates project the company’s profits relative to the number of shares outstanding, and they’re one of the most-cited metrics when determining a firm’s value. Upon a company’s quarterly earnings release, “beating” or “missing” estimates can swing the share price.
Price to Sales (P/S) Ratio: the current share price divided by revenue per share. P/S ratios are best used to compare companies within the same industry, as profit margins can vary significantly across industries. Relatively lower P/S ratios mean stock is undervalued based on its revenue, while higher P/S ratios may mean the stock’s price is inflated. Keep in mind, future expectations for higher revenue may be “priced into” a new stock’s price.
Enterprise Value to Revenues (EV/Revenues): the current value of the firm relative to its sales. A higher EV/Revenues ratio means a company may be overvalued, and vice-versa.
New stocks on the market have limited trading histories; for those that have been on the market a little longer, there are some other metrics and estimates to evaluate the stock’s potential for growth:
Price to Earnings Growth (PEG Ratio): the company’s P/E ratio divided by its growth rate. The PEG ratio allows investors to compare companies across industries with different P/E ratios and growth rates; a PEG ratio equal to 1 is considered fair-valued, while lower than 1 is undervalued for its growth rate, and higher than 1 is overvalued.
Forward Price to Earnings (P/E) Ratio: the current share price divided by Wall Street analysts’ predicted earnings per share. If a company’s Forward P/E Ratio is lower than its current P/E ratio, earnings are expected to increase.
Investing in Direct Listings & SPACs
In the last few years, several stocks have gone public through Direct Listings. Your clients may have asked about Spotify (SPOT), or the Palantir (PLTR) direct listing, and what the difference between a traditional IPO and direct listing really is. Also known as a Direct Public Offering or Direct Placement, a direct listing is when a private company offers their shares directly on a stock exchange, bypassing the traditional underwriters and roadshow. A company may choose a direct listing over an IPO if they are confident there is already enough demand for their stock from the public, or if they wish to avoid a lockup period.
For investors, the key differentiators of a direct listing versus an IPO is less guaranteed demand for shares, and earlier opportunities for company insiders to sell shares. Both can impact a new IPO stock’s share price.
Recently, SPACs have become a hot topic. Your clients may be asking what these are, and even more importantly, how can they invest? Special Purpose Acquisition Companies (SPACs) are shell companies that go public for the sole purpose of later acquiring a private company. SPACs can help streamline the IPO process for private companies, and often pay higher share prices to the company than an IPO would. After the SPAC acquires a private company, it will assume that company’s identity, and shares will be traded publicly as such. Read more about SPACs here, and find current public SPACs within the shell companies subsector on YCharts.
Investors face additional risk when buying shares in SPACs, in that no one knows what company the SPAC will acquire. Essentially, shareholders are investing their money in the SPAC management team’s ability to find and acquire a quality company. The chart below shows several major SPACs trading on speculation alone.
Should You Invest in An Upcoming IPO?
New IPO stocks can be risky. Newly listed companies lack the historical performance metrics and track record of more established firms. If your client is interested in a new stock, here are few things to consider:
What is your client’s risk appetite? Are they more risk-averse and uncomfortable with large losses, or do they have a higher tolerance? Your client’s risk profile is the main determinant of whether investing in new IPO stocks is suitable for them.
What is your client’s portfolio composition? An IPO stock may require more frequent monitoring and evaluation — determine if the additional due diligence is consistent with the size and composition of a client’s portfolio.
Have you considered dollar-cost-averaging? By slowly accumulating shares, you can avoid the risk of mistiming an investment, mitigate some potential volatility, and build your client’s position over time.
Using YCharts to Evaluate New IPO Stocks
Several tools and templates on YCharts help you evaluate new IPOs on the market. Below are just a few examples of how YCharts can enable your analysis and help you better communicate with your clients.
When looking for new stocks to invest in, or analyzing their performance, the YCharts Stock Screener helps you identify the best opportunities.
The Recent Positive IPOs and Recent Negative IPOs template screens are available in the Stock Screener and identify the best (and worst) performing IPOs from the past year. See the results of the Recent Positive IPOs screen as an example.
Custom Email Reports
Once you’ve built a screen of IPO stocks to monitor, keep yourself (and your clients) up-to-date on how they’re performing with Custom Email Reports. Automatically sent to you at the frequency of your choice, Email Reports can include a variety of different visuals and data tables covering stocks, equity sectors, and other data important to your research process.
Below is a Custom Email Report that captures performance and trading volume trends for new IPO stocks within the communication services sector. The list of IPO stocks was created via the Stock Screener before being added to the Email Report.
Given the potential for volatility in a new IPO stock’s price, you’ll want to keep close track of price movements.
Create a Watchlist on your Dashboard of the new stocks you’re monitoring, then add relevant metrics like IPO date, quarterly revenue estimate, quarterly EPS estimate, and YTD daily price returns. See below a Watchlist of hot IPO stocks, including Snowflake (SNOW), Lemonade (LMND), DraftKings (DKNG), and Casper Sleep (CSPR).
To customize your Watchlist, navigate to Options in the top right corner of your Watchlist, click Add Info Column to Data View or Add Metric to Data View, and select the information or data you like to check on a regular basis.
To stay up to date on news such as earnings reports and estimate revisions for new IPO stocks, set customizable Alerts on your Watchlist. To set up an alert, go to Options, select Create/Edit Alerts, and then select from pre-made alert options, or create your own alerts based on changes in the metrics you care about most.
As an advisor, these tools allow you to conduct proper due diligence, and effectively communicate your IPO findings and recommendations to clients.
Connect With YCharts
Interested in adding YCharts to your technology stack? Sign up for a 7-Day Free Trial.
©2020 YCharts, Inc. All Rights Reserved. YCharts, Inc. (“YCharts”) is not registered with the U.S. Securities and Exchange Commission (or with the securities regulatory authority or body of any state or any other jurisdiction) as an investment adviser, broker-dealer or in any other capacity, and does not purport to provide investment advice or make investment recommendations. This report has been generated through application of the analytical tools and data provided through ycharts.com and is intended solely to assist you or your investment or other adviser(s) in conducting investment research. You should not construe this report as an offer to buy or sell, as a solicitation of an offer to buy or sell, or as a recommendation to buy, sell, hold or trade, any security or other financial instrument. For further information regarding your use of this report, please go to: ycharts.com/about/disclosure