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 www.iporesources.org.
* 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.

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