The Truth Behind Those Astounding IPO Returns
IPO shares may look like they deliver eye-watering returns but the reality may be very different. It’s all in the way the returns are calculated.
Snowflake’s IPO was big news last week. The software company’s shares opened for trading last Wednesday afternoon at $245 per share, more than double the $120 initial price. They swiftly shot upwards, at one point touching $319, before pulling back to close at $260.
Fast forward one week and SNOW shares have slid to $213. Who knows when - or if? - investors who bought shares on the opening day will realize a profit. They could be in for a long wait.
Meanwhile, Snowflake’s network of institutional investors, including Warren Buffett’s Berkshire Hathaway, who were lucky enough to buy big chunks of SNOW directly from the company at the initial $120 price, are sitting on a 78% return.
That’s a totally different IPO investment compared to retail investors, even though they both invested in the same company on the same day.
IPOs: A Tale Of Two Returns
We’ve all read about rags-to-riches IPO stocks that outpeform the market. But are investors really pocketing these double or triple-digit gains? The answer is: Depends who you are.
A quick dig into how IPO returns are reported in the news reveals many analysts overstate the profits earned by investors who bought them on the first day of trading.
That’s because they calculate the returns using the share’s initial price, rather than its market price. The initial price can be much lower - and thus make the gains look much higher - than if the returns were calculated using the market price investors paid when the shares began trading.
The initial price is set by the company and its team of bankers, and together with the number of shares issued, determines the value of the equity capital the company raises in the IPO. The shares are sold at the initial price to an exclusive syndicate of institutional investors and company insiders who then hold them or sell them on to retail buyers in the open market.
When the shares begin trading, their market price can be much higher than the initial price. For hotly anticipated IPOs the differential can be massive, as was the case for Snowflake (SNOW) shares (initial price of $120; market price of $245) and JFrog (FROG), whose shares were initially priced at $44 but opened for trading at $71.27, an increase of 62%.
If you were an individual investor that bought SNOW on its opening day, chances are you paid an even higher price than the opening market price, further cutting into those future returns.
When IPO returns are recalculated based on the market price paid by retail investors, they tell a more sobering tale about the reality of buying newly listed companies.
Take fintech startup TradeWeb (TW), featured in Yahoo Finance’s list of the ‘Top 5 Performing IPOs of 2019’. The article reports the shares climbed 68% (as of December 2019, when the list was compiled). The figure was calculated using TW’s initial price of $27, not the opening price in the market of $36.58. If you were one of those first-day investors who paid $36.58, you’d be sitting on a tidy profit of 24% - nothing to spit on, but not 68%.
Another stock on the list, Bridge BioPharma (BBIO), reportedly rose 117% since its IPO in June 2019 (as of December 2019, when BBIO shares were trading at $36.) The gain was calculated using BBIO’s initial price of $17. But the shares began trading at $30.61, equating to a return of just 17% for first-day buyers.
The Fizzle After The IPO Pop
The initial surge in an IPO share’s price is a hard act to follow, and for many stocks those first-day gains form the backbone of their longer term returns. Since Yahoo Finance published its 2019 IPO list last December, BBIO shares have risen a further 5%, a far tamer pace of growth than when they first hit the market.
It’s no secret that skyrocketing IPO shares can quickly taper, which is all the more reason why investors need to ensure they aren’t paying too high a premium for shares that may not have any wind left in their sails. Expensive opening prices are great news for institutional investors who bought the shares at the initial price, but for retail buyers the road ahead may be much a long and windy one if they’re not careful.
Investing In The Right IPOs
It’s not all bad news for investors looking for a piece of the IPO action, and plenty of new listings have scored fantastic gains in the open market.
Reading about previous IPOs that delivered kickass returns to retail investors is a great way to learn how to scout for new shares with similar potential. The Motley Fool calculates IPO returns from the perspective of the normal investor, using market prices to calculate returns, including this compilation of last year’s most successful IPOs. Hint: The best IPOs are often not the headline makers garnering all the media attention, but lesser known companies raising smaller amounts of capital.
Many financial websites like Marketwatch have dedicated sections that track IPO news, including an IPO calendar of upcoming listings. IPO Monitor and IPOScoop have information on everything IPO-related, including helpful tips for spotting attractive IPO stocks.
Unless you’re lucky enough to be chums with the likes of Warren Buffett, chances are you won’t be asked to participate in the initial sale of shares directly from the company. But there are exceptions. It’s worth calling your broker to see if they have direct access to any upcoming IPO listings.
If dropping cash into a fledgling company feels too intimidating, consider buying an IPO-focused ETF that spreads the risk. The Renaissance IPO ETF invests in a basket of recent US-listed IPOs. The fund acquires issues within 90 days or sooner of an IPO and sells them after two years.
Whatever you do, make sure you look beyond the headline hype and don’t get caught falling for overpriced IPOs that can’t deliver on their promises.