Many investors forget that most IPOs utterly fail to live up to their promise after they are issued. A study by Tim Loughran and Jay Ritter followed every operating company (almost 5,000) that went public between 1970 and 1990. Those who bought at the market price on the first day of trading and held the stock for 5 years reaped an average annual return of 11 percent. Those who invested in companies of the same size on the same days that the IPOs were purchased gave investors a 14 percent annual return. And these data do not include the IPO price collapse in 2001.
The fact is often ignored, but IPOs are bad investments on the whole. The real money is made only on the hottest deals, but only an investment bank's best clients get shares at the offering price for those stocks. With hype and exposure at a peak, the sellers can usually succeed in getting top dollar, leaving individual investors set up for below-average returns.
Vonage (NYSE:VG) is one recent example. The underwriters valued the firm at $17 per share when the company went public. Now only weeks later, the same banks' analysts have initiated coverage of the stock with neutral ratings and price targets between $9 and $11 per share. Aside from some bad publicity, nothing about the business has changed.
The Vonage example just goes to show you that, like most things where money is involved, people selling you something have inherent conflicts of interest. They are trying to maximize their cut. The only way to ensure you get a good price is to do your homework. I'd guess that at least 90% of the people who bought the Vonage IPO at $17 did no valuation analysis whatsoever.
Those that did were correct in avoiding the deal, as the current $7 share price shows. If the stock was really worth far more than $17, don't you think they would have sold it for more than that?
Retail investors need to be careful with IPOs, as history is not on their side.