Trillionaire Term of the Day - January 27, 2009 - IPO's

Initial Public Offering (IPO)

Have you ever wondered why you can trade shares of Apple (AAPL)? Do you know why you have the right to buy a portion of Verizon (VZ)? How did these companies, and many others, come to be traded on public stock exchanges? You can answer all of these questions and more with a good understanding of Initial Public Offerings (IPO’s).

Most basically, an IPO is the very first sale of a company’s stock to the public. Conducting an Initial Public Offering is often called ‘going public’ because private companies open themselves to public inspection and investment. To go public, a company must follow SEC (Securities and Exchange Commission) guidelines and report financial information each quarter. The guidelines are designed to protect investors from corporate fraud, so companies must provide a good amount of information to meet the strict standards set by the SEC. Their balance sheets, income statements, and other financial statements must be available for anyone and everyone to read. So why would any company open themselves up to such great amounts of examination and scrutiny?

The answer: Money. Well, money and other benefits. Small private companies conduct IPO’s to get the cash and capital needed to expand quickly. Large private companies give public offerings to gain money and other advantages that stocks provide as well. These advantages include, incentives to attract powerful employees through stock options, support to take on more debt, and the prestige that comes with being a publicly traded company, amongst others. We now know why companies conduct IPO’s, but how do they do it?

They do it with the help of investments banks. Investment banks (think Goldman Sachs, Merrill Lynch) act as ‘underwriters’ that help companies create and submit Initial Public Offerings to the SEC for approval and to the public for sale. Unfortunately, the underwriters usually only sell stocks in IPO’s to institutional investors (the people with a lot of money to invest), so if you’re a little guy, it’s very hard to get in on a fresh IPO.

The most fascinating part about Initial Public Offerings is that they really aren’t offering anything tangible! You see, you get nothing in return for your purchase of stock other than the shares themselves. Technically, you receive the rights that go along with having a very small portion of a company and the dividends that are paid out to shareholders, but that’s it. The stock price is not a reflection of any true physical property of the company, it is simply decided upon by the underwriter and offering company. The price is set high enough to make the offering company money, but low enough to create demand for potential buyers. If the company’s stock price plummeted to zero the day after an IPO, you would be left with nothing. While this scenario is a bit extreme, it should key you in to the risk that goes along with investing in an IPO.

The risk is magnified by the lack of information available for companies that were previously privately owned. The specific history of a company that conducts an IPO is not available to the public, so it becomes very difficult to do the normal research that is conducted before making an investment. Additionally, IPO’s are often hyped up by the underwriters that create them in an effort to entice investors into buying.

So, while you may not be participating in an Initial Public Offering because of their exclusive nature and inherent risk, it is very advantageous to understand how a company arrives on the stock market in the first place and how its stock price was first determined. And at College Trillionaires, we’re all about providing you with advantages.

 

-Matt Schwartz

College Trillionaire