Should You Invest In an Initial Public Offering?

Facebook recently filed for an initial public offering (IPO) to raise $5 billion in its IPO, putting its total valuation at $100 billion. Many investors, both institutional and individual, are drooling over the prospects of buying into the hottest company on the block – for now.

I say for now, because other investors are questioning how profitable the social network is, how fast revenues are growing, and whether the company is worth a $5 billion valuation. (It will be three times more expensive than Google was at its IPO).

Thus the question: should the typical Joe Investor consider investing in Facebook or any other hot company?

A Dicey Prospect

Buying an IPO can be a dicey prospect for the retail investor. Consider LinkedIn, which had its IPO last year. The company’s stock soared as high as $122.70 on its first trading day, but hasn’t maintained it since (it’s currently priced in the 80s). This suggests that many people who bought the stock during the first few days of trading were buying high, then watching their losses pile up.

Another problem with buying into IPOs: the buying frenzy quickly turns into a selling one, with some investors dumping the stock to take their profits and run, which could negatively affect buy-and-hold investors. According to SigFig, a portfolio management tracking service, more than 20 percent of people who bought Groupon on the day it went public last year dumped the stock on the same day (it’s currently trading lower than its IPO share price), and the percentage was higher for Zynga, the Facebook game developer, which is currently trading higher.

Privileged Investors Get the Sweetest Deal

Ironically, the IPO of the world’s largest social network is nearly closed off to the masses. As with most IPOs, Facebook will only be sold at the offering price to privileged investors. Most regular investors who want a piece will have to wait until shares start trading on the stock market, possibly at a price much higher than what was offered to the initial investors.

When it comes time for a company’s shares to be sold, they’re typically first offered to large mutual funds and pension funds, which are most able to buy the largest amounts of stock. Meanwhile, the major investment banks leading the deal may allow some of their best customers, (usually the “one-percenter” individuals with high-net worth) to buy shares at the IPO price. Once the stock starts to trade on the exchange, those privileged investors may then sell into the open market, where all investors compete to buy the shares. Most likely, if demand is as strong as expected, the share price jumps, forcing regular investors to pay up for the shares.

Will Facebook Outperform the Typical IPO?

“With Facebook, the biggest gains will likely be for those investors who get shares at the IPO price,” says Jay Ritter, professor of finance at the University of Florida. He warns investors who are locked out of the IPO to be careful if they rush into the market, because IPOs typically underperform in the stock market within the 7 to 24 months following the first-day close.

“Most companies hit their earnings projections the first quarter or two after the IPO. But after that, if the business model isn’t working, that’s when the bad performance kicks in.”

Can Investing In an IPO Pan Out?

In many instances, it has. If you had bought into the IPOs of Microsoft, Starbucks or Wal-Mart, you would have had some volatile ups and downs in stock price along the way, but you would obviously have made enough money to make a dent in your standard of living. A good example of this is, a single share of Coca-Cola purchased for $40 at the IPO in 1919 crashed to $19 the following year. But today, that one share, with dividends reinvested, is worth over $5 million. So, a well-chosen IPO investment can be a life-changing experience.

On the other hand, think if you had invested in a formerly hot “dot-com” company, like WebVan back in 1999. The bankrupt web grocer left its investors with total losses.

Questions To Ask Yourself

Despite a company’s high-profile name, it’s still wise to tread carefully when considering investing in an initial public offering. Ritter suggests investors ask themselves these questions before investing in any IPO:

“Will this business grow at a high enough rate to justify its stock price?”

“What competitive advantages does this business have? Patents? Trademarks? Key executives?”

“Is the company’s business model and financial foundation sustainable, or could it be made obsolete by advantages in technology?”

“Would you be comfortable owning this business if the stock market were to close for the next 30 years?”

“If the stock falls by half due to short-term problems with the business, can you keep holding on without getting emotional if you think the company’s long-term potential still looks good?”

The Bottom Line

When it comes to IPOs in general, look for viable, long-term business models and profitability. Don’t let emotions take over. Instead, make a rational investment decision and invest for the long haul. That kind of strategy builds wealth over time and allows you to sleep at night.

Vanessa Richardson is a freelance writer in San Francisco who writes about small business and personal finance.