How to Make Money From an IPO

Stock traders spring into action after an IPO.

Stock traders spring into action after an IPO.

Initial public offerings are often described as the stuff of dreams — both for the original stockholders of the company and the outside investors frantically trying to get a piece of the action. It creates thoughts of easy money, if only you could get a few shares. However, not all investors who buy IPOs make money. The best way to make money by investing in IPOs is to know something about how they are managed, so you don't get stuck holding losing shares.

Syndication

Investment bankers use syndicated underwriting to take private companies to the public. The number of investment banking firms participating depends on the size of the stock offering. For you, the investor, historically the larger the group of banks, the more likely the IPO will trade up after issue. In a traditional IPO, the lead underwriter buys the entire issue from the issuing company on the day of pricing. To do that, the lead underwriter invites other banks to participate by sharing the cost of buying the issue. This is called syndication. Every bank that participates will receive fees for the use of its money. These fees include the commission paid to the broker who sells the shares. If you are buying IPO shares, as an investor, you have already made some money because you don't have to pay additional commission on top of the cost of your shares, as you would if you were buying shares in the open market. With the low commissions available at the online discount brokers, this is not that big a deal, but it does make it seem like you are getting a good price on the stock you purchase.

Pricing

Syndicates want the IPOs they underwrite to trade up in price after the stock is issued. The idea of being able to make nearly guaranteed profits on IPO purchases is what keeps investors coming back for more IPOs. That makes the investment banker's job of underwriting IPOs easier. You are an example of the power of this image. If you thought you couldn't make money on an IPO, you wouldn't be reading this article. So, most IPOs are issued at a price that represents a discount to what the investment banker thinks the stock is actually worth. For example, if a company's asset value and future prospects make its stock worth $20 a share, the underwriter might price the IPO at $15 a share to create demand.

Pre-Sale

The price is established through pre-selling the issue to investors. Since big institutions buy the majority of most IPO issues, the underwriter puts out "price talk" to see at what price the institutions will buy. It is a way of negotiating to arrive at a successful pricing. If you were a founder or employee of the company, or invested in an early private placement of the stock, you might be paid somewhere between $10 and $12.50 per share for your stock. The rest of the share price will go to the underwriters for their fees. During this pre-sale period, the underwriter will oversubscribe the issue. That means that more shares will be sold to investors than are being offered. The original shareholders do not participate in the oversubscribed shares.

Oversubscription

The underwriter oversubscribes the IPO to protect the success of the issue. If an institution decides at the last moment not to buy shares, enough stock has been sold to other investors that the IPO can go forward. If the issue had not been oversubscribed, the IPO would likely be postponed. The postponement of an IPO is not a good sign, unless there is some external crisis disrupting the market. An IPO that goes forward in a bad market is likely to get sucked down with the market, and you will be stuck with shares trading at a lower price than you paid. If you are an early shareholder and your IPO is postponed, don't make any financial commitments until the stock is actually sold. Postponements can go on for months and some issues eventually get cancelled.

Stabilization

Part of the underwriter's job is to support the price of the post-IPO stock. Most IPO investors hope the stock jumps in price as people rush in to buy the issue. The early buying is at least partly done by the underwriter's traders, covering their short positions as close to the offering price as possible. Other investors are also trying to buy in to take advantage of price appreciation as the stock trades higher. If you participated in the IPO, place your sell order at a conservative 10 percent higher than the offering price, or higher if you feel the stock will trade up significantly. The best way to make money on an IPO is to sell out on the first post-issue jump in price. Profit taking will probably drive the stock price back down to the issue price and, if you place an order to buy stock at slightly above the issue price, you may be able to ride the stock price back up. Often, the stock will be somewhat volatile during the days immediately following an IPO, giving you a chance to trade the stock. If your goal is to make a quick profit in the IPO, don't hold it too long or you may get stuck with your shares. Many savvy IPO buyers wait until 60 days have passed, which is the usual time an underwriter will support an IPO. In many cases, you can buy the stock at or below the issue price if you wait.

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