5 Questions You Must Answer Before Buying Into an IPO

By David Sterman
April 15, 2011

If you're a fan of initial public offerings (IPOs), happy days are here again.

It's been more than a decade since investors were caught up in the crazy days of the technology boom that saw stocks soar to unbelievable heights.

Some of the biggest profits were made (and lost) buying up shares of IPOs. That whole era ended quite badly, but for a handful of especially savvy investors, real fortunes were made before the boom went bust.

Investors who are the best at navigating IPOs know one thing for sure -- not all deals are bargains. Here are five things a successful investor must consider before investing in a newly public company:

1. Is the company raising enough money?

Many companies raise money in an IPO with plans to come back and raise more money in a year or two (known as a secondary offering). The trouble is, investors start selling shares the instant they catch a whiff of a secondary offering.

That's because if demand is low for new shares created in the secondary offering, bankers will have to lower the price to drum up interest. And lowering the price on a secondary offering will automatically lower the price of the shares that are already trading.

For example, battery maker A123 Systems (Nasdaq: AONE) was forced to come back for more funds twice -- less than 18 months after it pulled off its IPO. And each time the idea of a secondary offering was raised, its shares took a serious beating. Those investors who got in early during A123's IPO probably rue the day they ever got involved with the company.

2. Does the company have too much debt?

The main point of an IPO is to raise enough capital to clean up the balance sheet and grow the business. But some deals are done simply because the company's investors have sucked all the money out of the business and loaded it up with debt in the hopes of flipping it to new investors.

For example, Hertz Global Holdings (NYSE: HTZ) was taken public by its private equity (PE) backers in late 2006 after they loaded it up with $12 billion in debt. Shares of Hertz eventually plunged from $25 to $3 as investors feared the debt load would choke the company. Shares of Hertz rebounded once the economy sprang back to life, but it's precisely these kinds of IPOs that would be in real trouble if the economy turned south again.

3. Is this a "me-too" deal?

In the IPO market, success begets success. If a leading player in an industry pulls off a popular IPO, all of its rivals will sit up and take note. So when the bankers come calling with an offer to put together an IPO, it seems like the right move.

The trouble is, once a bunch of companies in the same industry all raise a lot of money, they start spending heavily on new products, advertising, acquisitions and anything else that will give them a return on their IPO proceeds. Before you know it, the whole industry is distorted as spending rises too high and profits start to slump. Any time you see a host of companies going public at the same time, you should probably think about cashing out.

As an example, several real estate companies, such as Excel Realty Trust (NYSE: EXL), recently raised IPO money with a focus on buying up strip malls. But with all of those companies pursing the same properties, the competition they created among themselves meant they would likely overpay for whatever property they could get their hands on. And that's not good for investors.

4. Has the IPO been delayed several times?

Ask your broker about the history of the IPO. Sometimes you'll discover that this is a company's second or third attempt at going public. And that's trouble. Repeated attempts to go public means that investors had little interest the first or second time around. If those previous investors looked at a possible deal and took a pass, that's a likely sign that the company has some unappealing aspects.

5. Does management have a good track record?

When I look at IPOs, I like to trace the history of management. Do they have a good track record with previous companies? More specifically, have they made money for investors in the past? Quality companies will seek to hire savvy, experienced managers a year or two before a company comes public.

Conversely, if management does not have much of a track record besides starting that business, they may be in over their heads. There are a ton of examples of people who are outstanding entrepreneurs, but not very good business managers; running a public company takes a completely different set of skills than starting up a company.

The Investing Answer: IPOs can make you plenty of money -- if you find the right deal. I actually prefer to wait these deals out with the hope that I'll find some gems after the (almost) inevitable post-IPO price slump. Regardless, it's hard to ignore the IPO market now that it's gearing up for a banner year. With the proper research, a well-timed investment in a solid IPO can make for a very good year, indeed.

[Learn more in the InvestingAnswers feature: How to Profit When Your Favorite Company Goes Public]