Five Ways to Assess IPO Stocks

— -- Should you invest in an initial public offering (IPO), the first shares offered by a new public company? A client asked me that question recently. I responded that, as is often the case in investing, this depends on a lot of factors.

IPOs of companies that have acquired pre-launch renown, such as Facebook in 2012 or Alibaba in September 2014, draw a lot of media attention. Media outlets tend to focus on how much company founders profit early on from IPOs, and like to show them ringing the bell to open exchanges, chattering endlessly about their newfound wealth.

But before you get caught up in the glitz, glamor and appearance of easy money, you might want to take a deep breath and wait a bit. An IPO should be researched just as thoroughly as any other company you may be interested in, as it’s easy to make errors that could be hazardous to your wealth.

When deciding whether to invest your hard-earned money in an IPO, you’ll want to look at the sales and earnings history of the company and other fundamental metrics, just as you would a company that has been around a long time. However, buying shares of IPOs is often much trickier than investing in established stocks because there may be limited information available about past sales and earnings – and, some companies go public before ever turning a profit.

As IPO companies are listed on the open market for the first time, they lack performance charts. Chart analysis, or technical analysis, is used by many professional traders and institutional investors, like mutual funds and pensions, to help determine at what price points to buy or sell.

A stock is only worth what someone is willing to pay for it, but at the beginning of an IPO, many times there are more buyers than sellers. Sure, there might be some day traders or other short term stock jockeys that will be looking to get in on the first morning and then sell quickly, or clients of an investment bank syndicate that got an allocation of shares and are looking for a short-term profit. However, many of the early, private investors, employees and other insiders have a lock-up period that governs when they can sell--often, not until 90 days or more post-launch.

Investors with IPO fever often push up the share price steeply in the first few weeks, only to regret this a few months later after the shares dip below what they paid and level off. Regret can turn into remorse when this plateau persists.

You can significantly lessen the chances of having this remorse by developing a sound process for evaluating IPOs – one that’s based not on irrational exuberance but on an understanding of the peculiar dynamics of this unpredictable embryonic period of new public stocks.

Here are five points to keep in mind when considering IPOs:

On May 23, 2012, Facebook was priced by the investment bank syndicate at $38 per share, and quickly reached a high of $45 before closing for the day at $38.23. Three months later, in August of 2012, the stock was trading around $18. It wasn’t until a year later, in August of 2013 that it broke out above $38. Investors who prudently waited and bought in low after the dip were eventually rewarded.

In September 2014, shares of Alibaba’s IPO were priced at $68. It surged 38 percent to over $90 that first day, but was trading in the mid-80’s a month later. It then started a steep run-up, topping out at $120 by November only to retreat back to the mid-80’s. This type of volatility isn’t uncommon for an IPO – and why some liken investing in an IPO to gambling.

The less you know about a company's business prospects--and early on, there’s often precious little to be known -- the more you’re gambling. By waiting to get in--or not buying at all--you may sometimes miss out on profits, as some IPO’s will immediately climb higher without ever pulling back. If you feel strongly about a stock and don’t mind waiting it out, then buying on the first day might be for you. If you are determined to invest early in an IPO, you might consider buying half of your intended position size the first day, and then waiting to buy the other half to see if there’s a pullback.

But even with more information, investing too heavily in IPOs increases your total portfolio risk. Keep in mind that IPOs are riskier than established stocks, so your holdings in them should reflect your overall risk tolerance. For many investors, this means that IPOs should comprise a small fraction of their total investment in stocks.

The author owns no shares of Facebook or Alibaba, and has no plans to purchase either in the near future.

This column is the opinion of the author and in no way reflects the opinion of ABC News.

Byron L. Studdard, a CERTIFIED FINANCIAL PLANNER™ practitioner, is founder and president of Studdard Financial, LLC, a fee-only financial advisory firm in Sarasota, Fla., dedicated to helping clients build wealth, protect it and pass it on to future generations. Studdard has been listed in the Guide to America's Best Financial Planners (published by the Consumers' Research Council of America, an independent research organization). He can be reached at Byron@studdardfinancial.com. If you have a question for him, send him an email and he will try to answer it in an upcoming column.