Airbnb, DoorDash and Snowflake made the top ten list of 2020’s biggest IPOs. It was a record-breaking year for companies going public, even with the uncertainty brought on by the COVID-19 pandemic, and those who invested in the right place at the right time. In this episode of The Agent of Wealth Podcast, Marc Bautis invites John Williams, Wealth Advisor at Bautis Financial, on the show to discuss if initial public offerings (IPOs) are good investments.
In this episode, you will learn:
- What is an initial public offering (IPO)?
- How to invest in an IPO.
- The pros and cons of investing in IPOs.
- Advice for what to do when your company IPOs.
- Indicators of a successful and unsuccessful IPO.
- How to determine the valuation of a company, including a discussion about accuracy.
- And more!
Bautis Financial: (862) 205-5000
Last year will definitely be known as the year of the COVID-19 virus, but in the stock market, we saw a resurgence of IPO chatter. Even starting in 2021 — after a little bit of low towards the end of the year — we’re seeing the hype again. I thought it would be an interesting topic to discuss.
Yeah, for sure. There was a record month in December and it’s continuing into January. We, on the practice side, have been getting a lot of calls and questions about them. I think it’s about time we start to work on explaining them, because there is a lot of confusion around what exactly an IPO is.
Beginning in the days that Facebook was an IPO, we’ve been asked if they are a good investment. But this past year, we’ve also had a lot of clients experience their companies IPO. And they want to know how to best manage that.
Before we get into it, I want to say that while John and I are financial advisors, we may not be your financial advisor. Before you make any investment decisions, please consult with a financial professional.
Towards the end of last year, two of the bigger IPOs were Airbnb and DoorDash. And we’re seeing a strong IPO season as this year starts. Before we start talking specifics about investing in them, can you give us the basics: What is an IPO? What are the mechanics of a company that is IPOing?
How A Company’s Success Kicks Off Its Initial Public Offering
There’s really two parts to this. But in general, an IPO is an exciting time for a company, right? It means a couple of different things, but mainly that the company is successful. They’re at this point where they’ve been working really, really hard and they now get to reap the benefits. The company is typically in a great spot, because it’s usually an indicator that the company has been profitable.
There is this word, what they call ‘unicorn status,’ which is when a company is at that billion dollar valuation. That being one of the times, and one of the signs, that a company is ready to take on the SEC regulations that are required to go IPO. And so when we hear about these IPOs, they’re usually companies that have made some noise. They are these disruptors — like Uber. I think that’s the start of this conversation: the success of the company.
You mentioned success a couple of times. Let’s go one more level down. At the start, there is a private company with a founder. It may have some owners, as well as some executive officers. At this level, everyone in the company gets “stock,” but because it’s a private company there’s really nothing you can do with it.
Now, the IPO is the event that allows those with stock to profit. They’re able to have the option of making money and getting “paid out.”
You mentioned profitable — which we will talk about in a little bit — because there are a lot of these companies that have IPO but are not profitable. But yes, like you said, it’s an exciting event for a company.
That’s why I treaded lightly around the talk of ‘unicorn status’: that one billion valuation. Because there’s been plenty of IPOs with companies, the ones we know very well today, that were not profitable. It was just the space that they’re in, and the momentum they had.
But in general, there’s two phases that lead to issuing a IPO:
- The pre-marketing phase.
- The implementation phase.
The pre-marketing phase is when the corporation will start to advertise their interest in going public, which involves reaching out and advertising the underwriters. Ultimately the underwriter (or underwriters) will help them get the word out and figure out the valuation of the company. As you can imagine, this is going to take some time.
The implementation phase includes forming a board of directors, implementing a process for audit and estimating the demand. There is a supply and demand portion of this, which we can get into a little bit more. But this phase includes understanding the demand.
Since these companies are private at this point, there is not a lot of public information available. Especially compared to publicly traded companies, who you can dig into to understand profitability before investing.
Finally, this leads to issuing the shares of the IPO, picking a date and coming up with the starting price per share.
Okay. That’s a good explanation of the mechanics, and we’ll hit upon a couple of points.
The first thing you were talking about was underwriting. Previously, or most of the time, this used to be the job of large, Wall Street banks — like Goldman Sachs or Morgan Stanley. Now, what we’re seeing a bit more is funds coming from SPACs (special-purpose acquisition company). They are coming in and helping companies go public.
The other point that you mentioned is that once a company goes public, there is a lot more transparency. Plus, they will acquire shareholders who will hold the company accountable for success, based off of quarterly results.
The hunger for good quarterly results is being pushed a lot. I think Facebook is the perfect example. When Mark Zuckerberg was running the company, and the company went public, the stock dropped. He was confused, wondering, ‘Well, what happened?’ Previously, he was focused on creativity — making a cool platform. But after going public, he learned very quickly that the bottom line does matter. User growth, acquisition and other key performance indicators mattered. Going public does change how a company operates.
I can imagine how hard it is to be in that position. Especially a guy like Zuck, he had all the control, he made decisions. For that to change overnight, I’m sure is a tough adjustment — especially for those who are not necessarily answering to anybody. After the company IPOs, they have a board of directors and profit runs the game. I can imagine it’s a tough adjustment from a lot of different angles.
So, Is an IPO a Good Investment?
Now comes the golden question: A new company is IPOing tomorrow, or next week, should you buy some?
One thing that is warranted is to look at IPOs performance: whether it’s right after they IPO or long-term. Unfortunately, there is not one answer that can be used across the board.
Like with anything, it comes down to the risk and return. We make sure that people understand that. Then, we help them make the decision, based off of their comfortability with the risk.
What Does an IPO’s First Day of Trading Tell Investors?
The dynamic of the first day is complicated. I think it’s important to understand what happens.
To give an example, let’s say that the underwriter decided the IPO is worth $20 a share. Most times, you will see a big jump up in price initially. Because what’s happening is, there are limited orders that people will put in, so there are only so many shares.
If you’re lucky enough to get in at that initial 10, 20, 30 minutes to an hour — when a lot of that action is happening — it’s really, really hard to get in at that $20 point. A lot of times you will end up buying at the peak of the initial jump — which isn’t necessarily bad per se — but it’s just that first jump. I don’t think a lot of people realize there is a lot of action on the first day.
And even sometimes you’ll hear that the IPO is going to be priced at $20, but it opens way above that — it doesn’t even trade it at 20.
A comparison is the New Jersey real estate market. Over here, you will frequently see realtors underpricing houses for sale, which created a feeding frenzy of buyers. The thought process is that underpricing is a better strategy than overpricing, which could lead to less demand. When IPO underwriters underprice, there’s an enormous amount of demand — and, from the start, it increases the share price. That’s one strategy that we see a lot.
And let’s back it up a bit. Before a company IPOs, CEOs, managers and employees may have an option to buy stock earlier on — and sometimes there are perks like partially vested programs. Companies can also offer friends and family opportunities to buy the stock. If you’re in these kinds of situations, then it’s a totally different conversation.
But if you’re a consumer, like you said, it might come out at $20, yet most people will be initially buying it at $40, $45. It can be difficult to determine if that jump is based off of hype or real fundamentals.
How to Determine the Valuation of a Company
You want to determine what the company’s valuation is. Knowing the stock price is one part of the equation, but you also have to understand how many shares the company has outstanding. With those two numbers you can determine the market cap of a company.. It’s one thing to say a company’s stock price is $43/share, but to know that the company is valued at $60 billion is a lot more telling on whether they are undervalued, overvalued, or accurately priced.
For example, there was a popular company that went IPO last year called Snowflake. There was a lot of hype around the IPO, just like there was with Airbnb and DoorDash.
Last year — pretty soon after they went live — DoorDash was valued at $56 billion (more than General Motors, for example). It had undoubtedly earned ‘unicorn status,’ but there was a lot of chatter that followed. People began to wonder if DoorDash had a viable business model, with potential for profitability of the investment. Similarly, a couple weeks after Airbnb went live, they were valued at $83 billion (more than FedEx at the time).
Everyone knew that Airbnb had a lot of potential to disrupt the hotel and travel market, but what people may not have known is that these positive projections were already priced into the company at the time it IPOs.
For someone wondering if they should invest, you must ask yourself, ‘does this company have more positive projections that we can expect?’.
Snowflake was worth over $100 billion, which was more than Goldman Sachs at the time. Some of those IPOs came back to earth a little bit last year, which I think is something that we see a lot.
After the initial spike, there is frequently some pullback as hype wears off. Can you talk about this dynamic?
Yeah. Whenever there’s hype involved, I always advise people to be cautious. It is difficult to determine how much of the price is built on hype, and how much of it is built on sound fundamental analysis.
I get the idea that sometimes you have to throw fundamental analysis to the wind: there’s a lot of bloated stocks out there, such as Tesla. When you do a fundamental analysis on Tesla it doesn’t make sense, but there are some things that can be built into a long-term expectation that somebody is doing.
That initial excitement is a dangerous spot to be in. In reality, the chatter could stem from someone offering advice with zero analysis to back it up. You have to be careful of the hype in the media.
Conversely, you can be on the right side of the hype and it works out. But our job is to make sure that the risk is known.
Just point out that some of these companies, yeah, they do ride up and they ride up even more and you look at the valuation and you’re thinking, ‘this is crazy.’ And then, it still goes up even more! But we also see the reverse happen too: where you’ll see a pop — almost a tease — and then it drops.
With Facebook, it turned out the best outcome came for long-term investments. If, as an investor, you could have handled the initial drop (where the stock price was halved). Looking back at that drop now, as an investor that stayed in, that 50% drop didn’t matter. But you had to be willing to stick with the company through it. Which, I think, is the attitude you need to have with IPOs. You need to like the company, believe in the company and hope it grows into the valuation.
To over simplify it: even believing that the company is doing well now, but thinking they can do better down the road, right? something as simple as just the company is doing well now, I think they can do a lot better down the road.
At the end of the day, we’re talking about profitability. The company — even if they’re not there today — have to get to that point. There is a reason why a company is going to have value and a lot of it is tied into revenue and profitability.
Again, Airbnb is a perfect example. I can see they’re the massive disruptor, right? But they’ve saturated the market. Right? How much more can they grow? How much more market share is there to have in that space? Just thinking about it, I would caution people to have a basis for why they’re buying it, other than just the hype.
Airbnb is one of the more unique ones: it was a riches to rags to riches story. The company held out on IPOing, and then the COVID-19 pandemic hit. During the pandemic, many thought it was the end of traveling. Consenquentaily, Airbnb would be a company that wouldn’t make it. But, in reality, Airbnb saw success because the COVID-19 pandemic led to near-term traveling, making U.S. Airbnbs perfect destinations. The success allowed Airbnb to reinstate their IPO, and it worked out.
Another route we’re seeing as of recently is companies holding back on IPOing, which there are a couple of different reasons for doing.
Staying Private: Advantages for the Company, Disadvantages for the Investors
Last year we saw it because the IPO market was so hot that the companies didn’t want to leave money on the table. So they held off in hopes of allowing their valuation to grow even more. That’s actually been a theme over the past couple of years, and that also falls on the negative side of investing in these.
What’s happening is a lot of the early investors (when public) are venture capitals and funds, who then get gains as the company is increasing revenues by 100% or 200%, and they’re almost sucking out all the gain. And then they’re IPOing, and they’re having the regular investors get stock. But at this point, a lot of the potential future gains have already been taken.
You sometimes forget the reason, but there is the raising money part of this too. Sometimes, the CEO of the company’s original shares may have been zero, and now they’re worth millions and millions. You can see why there is that part of it.
I was just talking to someone about Stripe. Back in October of 2020, they at an valuation of a little over $30 billion. They’re in this fintech payment space, a space that has exploded over the past couple of months. They just raised more money a couple of weeks ago, at a $96 billion valuation. But, they were supposed to go public last year. Instead, they pulled their IPO because the market was nuts.
Companies’ valuations are increasing, which leads them to think ‘if we IPO now, we might leave a lot on the table, so let’s wait until next year.’ While this can work out perfectly for the owners, it may not necessarily work out for the investors, because their valuation has almost tripled in that four- to five-month period.
Another thing that investors should look at is the history of the company and the price that it’s IPOing at. Does everything have to go perfect for this thing to keep going up? It’s a fine line a lot of times how successful these IPO’s are.
What you’ll notice with Shark Tank is that a lot of people come onto the show with their valuation, but there’s not always agreement as to whether or not it is correct. I think what’s really going on with Stripe is yes, they raised the money at that valuation, but it may not be correct.
Cash Flows and Valuation
There’s a lot of ways you can value a company. But one I use a lot is projection of future cash flows. It is a simple way to determine, for instance, or the next 20 years, how much the company will make. At a certain level, it is that simple.
That’s definitely the traditional way of valuing a company: looking at its cash flows, earnings and revenue growth. But, some of that relevance has changed recently. The comeback that you’ll get from some people is that you don’t have to look at cash flow at all, because a company is worth whatever someone will pay for it. What people are doing nowadays is buying on future projections. It’s a similar concept to a house, right? What’s a house worth? It’s whatever someone will pay for it.
Investors believe that if a stock goes up, it will go up again: so they buy it. Obviously we know that that doesn’t always happen, but to say that it’s just cash flows isn’t completely accurate. The dynamics of investing are different now.
Earlier we were talking about the effects of bad quarterly results. An example of this would be Netflix: their stock price hinges on how many subscribers they get. The market doesn’t care too much about their earnings or revenue, they focus solely on new subscribers. For other companies it’s different.
Some people look at stock prices and buy in as prices are going up, with the intention to sell as it’s going down. That simplicity has worked to an extent, but markets are dynamic and that strategy may work today, or it may have worked last year, but at some point it may not work anymore. And you could see some pretty substantial losses by taking that approach.
I think that the biggest takeaway from that is the lack of control you have over understanding that part of the price of the stock. Right? The hype. I get that it’s not as simple as just cash flows.
There’s also the other part of this that we haven’t touched on, which is the technical analysis. There’s the risk of the market falling which would affect everything.
Maybe I’m a little old school, but I believe the reason why we should buy stock in companies is because of their performance and value.
Investing Vs Speculating
Well, there’s definitely a difference between investing and speculating. If you’re investing for a purpose, you have something you’re looking to do, some goal, something in the future. Investments help you get there. Versus speculating. There is a difference between the two.
I said earlier, it’s not that we poo-poo investing in this or investing in that, it’s more about knowing what you’re getting into — upside and the downside — and making sure that:
- You’re comfortable with the potential on the downside.
- It’s not going to ruin your finances, whether it’s retiring by age 65 or having enough money to put your kids through college.
If you have some play money and want to invest in an IPO, go for it! But you want to make sure that it’s not going to wreck any part of your financial plan.
How to Invest in an IPO
That’s a good segue into how someone can invest in an IPO. Obviously the easy route is using your account (TD Ameritrade, Robinhood, E*TRADE, Schwab, etc.) and purchasing it, just like you’re purchasing any other stock.
There’s also a third option. Certain companies are looking for money, right? And they may have gone the venture capital route and raised money from a venture capital firm. But they can also pitch their company to regular investors, like you see in Shark Tank. There are some prerequisites to the investor, like whether or not they’re qualified or accredited — which is based on income and net worth. That’s another option, buying pre-IPO companies.
Earlier, you mentioned SPACs. In a SPAC, you’re basically a passive investor that funds a company who then evaluates a number of different, private companies. After evaluating, the SPAC decided to divvy up their funds among a number of those companies, with the hope that the companies either get acquired — which is a payout — or that that company goes public — which is, again, a payout.
There’s pros and cons to all these strategies, and there are more out there, there are more options out there. But remember, you have to weigh the pros and cons, and again, risk and return.
There’s something about not just investing in IPOs, but investing in stocks and securities in general, that I think is misunderstood. Anytime someone buys into an IPO or stock, there is someone on the other side that is selling. It doesn’t mean that one of you is wrong, one of you is right, but it’s just something to think about.
When it comes to risk, there’s a lot to think about. I worry about the people who have only been investing inside of this bull market because they don’t know what it is like to have lost, literally. I don’t want to be a Debbie Downer, but we are riding high now. So, if you are going to get involved, have it be part of a bigger plan.
All right, we’re just about out of time. Thanks for joining us, John. If anyone has questions about IPOs or investing in general, we’d be happy to talk: schedule a free consultation with us anytime.