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Pop goes the IPO — or does it?

About the author

Constance is a New York-based journalist who has written for the Atlantic, CNBC.com, Reuters, and other major publications.

Twitter goes public on Thursday. (Getty Images)

Twitter goes public on Thursday. (Getty Images)

The eagerly anticipated Twitter initial public offering debuts on the New York Stock Exchange Thursday.  Amid excitement and demand for the shares, the social network has already boosted its estimate of the shares’ value by 25% — a signal to some that IPOs are again heating up in the United States as investors look for fresh, potentially high-growth stocks.    

According to real-time information provider Dealogic, 190 IPOs have listed on US stock markets so far this year and most saw their share price rise on the first day of trading. Container Store shares, for instance, rose 101% the day they began trading 1 November.

IPOs in Europe, mainly in the UK, have also been strong as markets there rebound. Royal Mail, a UK postal service company, rose 38% on the first day of trading on the London Stock Exchange, although most first-day pops among European IPO stocks are more muted.

“Everyone is trying to find the next great IPO performer,” says Jim Krapfel, an equity strategist at investment research firm Morningstar.  “When people clamour for company shares, though, the deal is more likely overhyped.” 

That’s one big reason why experts say it is often better for average investors to avoid the siren call of the next hot IPO — at least at the start. What’s more, big institutional investors may get the bulk of the available shares for popular offerings and have access to more up-to-date financial information than do individual investors.

Buying a first-day IPO can be fool’s gold, say some experts, since many fall after a brief rise. Prosensa Holding NV, a Dutch biotech company, popped 48% its first day on the Nasdaq exchange in late June. Since then, the company’s shares have dropped 72%, according to Dealogic data.

“IPOs are meant to pop the first day,” explained John Edmunds, a professor of finance at Babson College in Massachusetts. The danger, though, is that a fast start means that future growth is already priced into the stock and investors who buy early on may end up seeing their sure thing turn into a disappointment.

Wait and see

Part of the IPO allure is getting in on the ground floor of owning a company. The day an IPO starts trading, investors are finally able to buy stock in companies that have usually been held only by private investors. Those private investors have often invested tens of millions in the fledging firm but don’t usually like to have their money tied up forever. Plus, they want to rake in the profits they’ve been waiting for.

Most IPOs allow those early investors — and employees who are granted shares before the IPO as incentive or compensation — to sell their stock after a few months. When they do, it almost always drags down the price of the stock because so many shares are coming into the open market at once, according to Robert Emens, a principal at GW & Wade Asset Management Company in Palo Alto, California.

“In reality, you’re coming in on something like the fifth floor,” explained Brian Hamilton, chairman of Sageworks, which analyses private company financials. “Other parties have almost always invested earlier at lower prices. You could be late to the party.”

If you’re really keen on owning a stock, “wait to buy when others aren’t looking”, said Krapfel. That is usually at least 25 days after an offering is listed.   

Behind the curtain

Gauging a company’s true, non-hyped IPO value can be hard to do. Newly public companies lack a long-term track record of revenue or profits, and have no analyst ratings to help investors compare the firm to any benchmark. Huge, hotly-anticipated offerings of big names like Facebook — and even Twitter — are more likely to be significantly overpriced compared to the actual value of the firm more than some other IPOs, Edmunds said.

Coltish IPOs are also more volatile during the first two years they’re listed. “IPOs can also get slammed 30% in one day,” said William Smith, chief executive officer at Renaissance Capital in Greenwich, Connecticut.

That high volatility can impact future performance. According to a study by the University of Florida, IPOs issued between 2000 and 2011 underperformed similar firms by 18% the first year and 6.3% the second. Five years later, however, that gap was nearly erased as the firms became more established and built a smoother track record. 

Despite the early price pop effect, today’s IPOs are still better quality — sporting better revenues and stronger profits — than companies that debuted during the dot-com era. “Back then, there was a feeding frenzy,” said Edmunds. Several company IPOs rose over 100% their first day of trading, and some didn’t even have positive cash flow at their IPO. That’s also the case with Twitter, which is one reason experts say investors should be cautious.

These days, investors are counselled to look for two essential IPO ingredients: revenue growth and profitability.  These ingredients help buoy an IPO’s stock price after the early excitement wears off. For example, Chipotle Mexican Grill, which was profitable before going public in 2006, is now trading at $543 per share. Its stock debuted at $22 per share.   

Remember, the stock market punishes companies — even big, exciting, next-best-thing ones — if they can’t sustain or produce earnings. When couponer Groupon went public in 2011, it wasn’t profitable and still isn’t. Shares now hover 50% below their offering price, said Hamilton.

As for Twitter, the company isn’t making money and recent reports about the decline in the number of new users worries onlookers. “Growth might be slowing,” said Edmunds.

“So what are investors really being offered?” Edmunds asked.

This story was produced under the BBC's guidelines for financial journalism. A full version of those guidelines can be found at bbc.co.uk/guidelines.

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IPOs are meant to pop the first day. — John Edmunds