THE BASICS #7: IPO
IPOs - the blind dates of investing.
After watching this video, you might be wondering: How is the IPO price determined? While it may seem like it’s pulled out of thin air, I assure you, it isn’t. The exact process is only known by the investment bank, but at the end of the day, it all comes down to one thing:
In THE BASICS #4, we established that a company’s valuation is the estimation of that company’s value. It’s important to remember that it is just that - an estimate. What you may be willing to pay for stock may be more or less than what I would pay for it.
Let’s say that there’s a very popular, national cake company that wants to start selling its cake overseas. To do that, it needs to raise $50 million to build a massive baking facility in another country. So it hires an investment bank to help raise that money through an IPO.
The founders are willing to sell 20% of their company. The bank decides to offer that 20% to the public by selling 5 million shares at $10 per share.
5 million shares x $10 per share = $50 million
How did they arrive at $10 per share? Remember:
Selling 20%, or 1/5, of the company for $50 million implies that the company as a whole is worth $250 million.
$50 million x 5 = $250 million
If the $50 million slice being sold is divided into 5 million slices (shares), then each slice would be worth $10. In other words, if someone is willing to pay $50 million for 5 million slices, that implies that they’re willing to pay $10 for each single slice ($10 per share x 5 million shares = $50 million).
BONUS: A GLIMPSE INTO THE PRIMARY MARKET
Let’s say that my investment fund wants to participate, or invest in, this cake company’s IPO, and we’re willing to buy $1 million worth of stock from the company. I, the analyst, would call the underwriter (the bank) and ask them two important questions:
- "How’s the order book coming?"
- This is critical from an investment perspective. I want to know how “hot” the deal is, or how many other investors are interested in buying stock. If there’s high demand (a lot of interest), that means there’s a good chance I’ll be able to make money on my investment.
- The bank will respond with something like “It’s oversubscribed” or “It’s two times oversubscribed”. If it’s two times oversubscribed, that means that, all together, people have put in orders for twice the number of shares for sale, or 10 million shares total. The company only wants to sell 5 million shares, though. Therefore, not everyone will get the full amount they’re asking for.
- "What’s the IPO price range?"
- The bank says “$8 to $12 per share”. I say “Great. Put me down for 100k shares at $10 per share” (total investment of $1 million). Bank says “Okay” and adds our request to the order book. How much stock I end up getting will depend on the overall demand for the stock, and how big of a business relationship I have with the bank.
The morning of the IPO, I get an email saying “Due to high demand, there wasn’t enough to fill everyone’s orders. You’ve been allotted (granted) 50k shares at $10 per share.” That means I bought $500k worth of stock in the IPO. 50k shares come into my fund’s account, and $500k goes to the company.
So how do I make money off of it?
Before the stock starts trading on the stock exchange, something called price discovery happens. People that couldn't buy stock in the primary market (like smaller investors and individuals), or primary investors who didn't get as many shares as they wanted, submit orders to buy and sell stock in the secondary market. Based on how many shares they want and how much they’re willing to pay for them, the stock exchange determines the opening price for the stock. If there’s a lot of demand and people are willing to pay more than $10 per share to own the stock, the opening price will be higher than the $10 per share that I paid for it. Once the stock goes “live” and starts trading, I may be able to sell the shares I have for $12, or maybe even $13 per share. If I’m able to sell my shares for $13 each, I would make $3 per share. On 50k shares, that’s a profit of $150k.
Now that's my kind of blind date.