IPO stands for Initial Public Offering and describes the process where a private entity offers its shares to the public for the first time.
If you have a private business and own all its shares, you can take some of these shares and sell them to the general public to raise money.
The primary reason for taking out an IPO is to tap the public for funds. After a certain size, it is not possible to grow your company with just your own money or depend on debt. This is when companies think of taking out an IPO and raise money for expansion.
The other big reason for taking out an IPO is to cash in on the success (or hype) of your company. By listing out shares in your company, you can sell it to the public and make money on something that was only in private hands earlier.
Why are IPOs so popular?
IPOs are quite popular with the general public across the world because they are perceived to make easy money for short term and long term investors alike.
Here is how it works: A company decides to take out an IPO, and fixes the number of shares and price, at which the offer will be made to the public.
Investors then apply for shares of this company, and normally, most IPOs get applications for more shares than the total offer. So, it is common to see that a company which offers 100 shares to the public gets applications for 200 shares. Since, the applications are more than the offer, companies make partial allotment to investors, and you may just get 5 shares, and get your money back for the remaining 5.
People are keen on getting in on IPOs because the price at which the IPO is offered is commonly perceived to be at a discount to the fair value. Due to this, when the stock lists, it zooms up, and makes a quick buck for the people who got in on the IPO.
Is this a sure way to profit?
The over subscription figures you see will make you think that IPOs are the easiest and surest way to make money, but nothing could be farther from the truth.
IPOs gained popularity because till a few years ago, it was common to see companies offer their shares at a discount to the public in an IPO. So, if analysts agree that the fair value of one share of your company is $100, you would offer your shares to the public for just $80 in an IPO.
When the stock listed on the stock exchange, it used to zoom up on the day of listing, and a lot of investors made a quick buck by selling the stock on the first day itself (called listing gains).
It is very rare to find IPOs that are priced at a discount nowadays. A lot of companies who havenâ€™t even started doing business yet, or whose promoters have tens of criminal cases against them come up with IPOs, and even they offer their shares at a decent price.
Sometimes it seems to me that the main objective of a lot of companies who come out with IPOs is to screw investors with it, and nothing more.
But, that doesnâ€™t mean that these stocks donâ€™t list at a premium, a lot of them still manage to list at a premium, which I think is primarily driven by hype and the sense of history.Â Â A lot of people have made significant money in the heyday of the IPO boom (or bubble?), and they find it hard to let go of such a simple money making scheme.
Investing in IPOs is just one more way of making or losing money in the stock market, and is not a sure or safe method at all. Its popularity may make it look like one, but it is not.
Eventually the IPO market will over heat, and a lot more people will burn their hands, than make money. But, the problem is that no one knows when that will happen and when the tide will turn, and till that time everyone will try their luck with it.