What Makes IPOs Different
Differences in Perceptions of Fundamentals with IPOs
One of the distinguishing features of an IPO is that its lack of prior history in the stock market will not constrain its price like we see with mature stocks. This phenomenon exerts its effects from both a technical and fundamental standpoint, and in a nutshell, brings to light the fact that with an IPO, no one is really sure what it is worth in the market.
While IPOs do have historical fundamental data, what is missing is how the public will view these fundamentals, and all fundamental data that matters to stocks are forward looking. So, this is to a large degree a matter of belief, of predicting, and IPOs lack a history of this,
It is a mistake to view the value of a stock purely fundamentally, because it isn’t really the fundamentals that drive the stock. At best, to the degree that people trading in a stock will do so purely based upon fundamentals, it is the perception of how these fundamentals will change over time that will drive the market.
A stock may be delivering a certain amount of earnings now, and present earnings will always be fully priced into the market, as this is well known to market participants. People buy stock to be held for various periods of time though, so the fundamentals in question will always be future ones, what sort of earnings that the company may attain at a point in time in the future for instance.
This of course involves forecasting, which can be pretty murky and involve a divergence of opinion, especially with companies whose businesses with higher potential for growth. This is why companies with more growth potential tend to trade at higher price to earnings ratios, people are not buying the stock so much on current earnings but on potential future ones.
The way that this potential is going to be perceived by the market is therefore a matter of some degree of subjectivity we could say, and therefore, with an IPO, especially with its relative lack of history of scrutiny, it becomes more difficult to predict how the market will perceive this future potential, in comparison to a mature stock where we already have a history of that under current conditions.
When the outlook for a stock changes, the stock will be subject to this period of re-evaluation, which usually results in greater volatility as we see how the market will ultimately digest this new information. With IPOs, this is the scenario the stock finds itself in at issue and in the early stages of its being available for trading, as the market settles in to discover the generally accepted long term valuation of the stock.
This longer term valuation is itself subject to frequent change though, and the stock may continue to climb for many years, for instance with what we saw with Microsoft. When we look at a monthly chart of MSFT, we see what looks like a constant rise in price over a period lasting almost 20 years, before things finally settled in to a significant consolidation followed by a decade of essentially sideways movement.
So, even though it may seem that the market has priced in an IPO’s longer term value after a certain run up, this process may not even be completed then and it may take a number of years for this to fully manifest. With IPOs though, the process is only beginning of course when the stock is issued and for those who seek to speculate on expanding fundamental outlooks, IPOs often provide ample opportunity to do so.