IPO Investing: Should you do it?
Hi, I’m Viram from Vested! We recently dug into whether IPO investing is actually a good idea or not for investors. Not so surprisingly, we reached the conclusion that it’s actually not a good idea. In today’s video we are going to walk you through the reasons why IPO investing might not be the best choice for your portfolio.
We are going to look at 3 things.
First, is what factors affect shareholder returns and how they are distorted during an IPO.
Second, we compare the returns between IPO investments versus non-IPO investments made during a common time period.
And third, we compare IPO returns based on a company’s revenue pre-IPO. Note that all of this analysis that we have done is based on US IPO data.
So let’s get started, first let’s look at how you as a shareholder gain returns.
There are 3 factors that contribute to a shareholder’s returns – 1st is shareholder yield, 2nd is growth of the company, and 3rd are the changes in valuation. Let’s discuss each of these in more detail before we get into the next section.
So 1st, Shareholder yield is basically the total amount of money a company returns to shareholders. The company does this by spending excess cash on either buying back shares or giving out dividends. The more cash a company spends to return to shareholders, the more returns that you as the investor will generate.
The next factor we look at is, growth.
Growth is the progress of a company that can be measured on the factors like its revenue, revenue basically means the total of all of its sales; or factors like earnings, which is the company’s profits, and lastly book value, which is essentially an accurate calculation of the company’s worth, and it also determines whether the company has enough assets to cover its liabilities.
The third factor, the most tricky one is, Valuation changes.
These valuation changes actually affect how you as a shareholder get return. These are tricky because they involve human assumptions.
Some investors use financial models that use a combination of interest rates and an assumption of the company’s growth rates to justify certain valuation changes, whereas others purely use narratives, stories, memes also today, or they are driven by FOMO which is Fear Of Missing Out to assess change in valuation.
The valuation change factor is actually the one that often gets investors into trouble, leading to investing in companies that might be over hyped.
When you put these 3 factors together, you get what we can call the returns equation for an investor.
Let’s look at how these factors are affected when a company is IPOing.
When a company is about to go public, there is a lot of hype around it on social media and traditional media channels. What this does is that it distorts the public image in the company’s favour, and affects the Valuation Change component which is people driven. People tend to overestimate the valuation change.
Another thing that happens when a company is about to go public is that the data around its Growth component, the second component that we saw is at the lowest level of availability. Basically you don’t have years or decades of growth track record to be able to understand the company better and to be able to value it correctly.
If you’re not convinced that shareholder return factors are distorted during an IPO let’s look at actual return data for IPO investing over the past 40 years. This data looks at over 8000 IPOs in the last 40 years!
The blue line on the chart represents the percentage returns if you had invested in all the IPO companies and held them for different time periods. Meanwhile, the orange line represents the percentage returns if you had invested in non-IPO companies of a similar valuation. As you can see, for most holding periods, investments in IPOs yielded a worse return compared to returns of non-IPO companies of similar size.
This underperformance has actually been true not just for a year or 2 years but across 40 years!
Next, we also looked at IPOs based on a company’s revenues.
What we realised is on average, IPO investments in companies with revenues less than US $100 million in the 12 months preceding the IPO, tend to underperform the market if you hold those investments for the next 3 years.
However, there’s also some good news that came out of the data if you are IPO enthusiast – investing in larger Tech IPOs is actually not so bad from a return standpoint. Let me show you why:
We compared IPO performance of tech companies with non-tech companies, and we saw that on average, larger tech IPOs, that is, IPOs of companies with revenue greater than $100 million in the last 12 months before the IPO, outperform the benchmark!
So, in conclusion,
When you think about investing in an IPO, you should ideally wait, since we saw that investing in IPOs yields worse returns than investing in the broader market over the same time period. Investing in an IPO also means you are investing near the peak of the hype cycle for a company. So, it may be best to wait, since it also allows you to also gather more data on the company.
Also, it’s better not to invest in smaller IPOs, companies that have smaller revenues. The data shows that investing in IPOs with very small revenues tends to lead to underperformance compared to the market, no matter how attractive the growth narrative sounds.
So that’s it from my end stay tuned for more!