In addition to the usual talk of bulls and bears, investors will soon hear more about “unicorns”—the term used to describe privately-held companies with values in excess of $1 billon. A number of these unicorns are planning to offer shares to investors through initial public offerings, or IPOs, so it’s probably a good time to examine the IPO market from an investor’s perspective.
University of Florida professor James Ritter has done extensive research of the IPO market. Using more than 30 years of data, Ritter found some interesting patterns in IPO returns. He found that share prices tend to rise on the first day of trading, about 18% on average. Despite this blazing start, IPOs tend to underperform the market over the next several years, and Ritter’s data shows that more than 60% of IPOs show negative absolute returns five years from their debuts. This suggests that IPOs may be attractive investments if you’re fortunate enough to be among the initial investors granted shares by the underwriting investment firms and you sell them the same day, but long-term investors should be cautious.
It’s interesting to consider some of the factors that contribute to this unusual price activity. First, because companies can choose the timing of the IPO, they’re likely to choose a time that’s advantageous to them—not investors. At the moment, stocks with attractive growth profiles seem especially in favor. Investors, too, know what sorts of shares have been performing well, and many speculators will be drawn by the momentum and hype surrounding the next new, fast-growing business. The initial price spike likely reflects this enthusiasm. But because many young businesses often struggle to achieve consistent profitability, company-specific operating issues likely account for much of the long-term underperformance. Since share prices eventually reflect operating performance, owners of unprofitable or marginally-profitable companies often find themselves swimming upstream. Consider ride-hailing firm Uber. It plans to offer shares to the public this year, and despite losing about $900 million per quarter, the company expects a valuation of around $100 billion. If an investor requires a fairly modest return on equity of 10% to justify making an investment, Uber will need to earn about $10 billion per year—more than twice what Starbucks earned last year—just to meet that threshold. That’s no easy task given their current losses.
Along with these high-profile offerings, you can expect to encounter various stories of IPOs that soared in their debuts and never looked back. While it’s true that some IPO buyers became early investors in companies like Microsoft, Amazon or Apple, you should also keep in mind that, like lottery winners, those who occasionally strike it rich in the IPO game are not representative of all who play. Despite this, we expect over the short term that IPOs, like lottery tickets, will remain quite popular.