Initial public offerings (IPOs) tend to attract a lot of investor interest, especially when the company is large and well-known. The excitement can be tempting, but it doesn't always lead to strong investment results. We encourage investors to look beyond the headlines and focus on whether the share price is supported by fundamentals, the company's progress toward sustainable profitability, and whether the potential volatility aligns with their goals and risk tolerance. Though familiarity with a product or brand can provide some comfort, it does not guarantee that the stock is reasonably priced, and investors in IPOs need to be more skeptical.

IPO Excitement Fades Fast

News coverage, especially for a large company, typically ramps up and drives excitement as the offering date approaches. The stock price of an IPO often rises on the day it begins trading relative to the publicized IPO price set by the security underwriters (known as the offer price). However, most individual investors do not receive share allocations at the offer price, as these shares are generally reserved for institutional investors. 

Instead, shares are bought in the secondary market after trading begins, frequently at prices that already reflect heightened demand and investor optimism. When compared to the secondary market's opening price, performance is often much less impressive, and returns can be negative for the days and weeks that follow. 

The historical price performance of 30 of the largest IPOs from companies in the Russell 3000 is illustrated in Table 1 and highlights this distinction between offer-price performance and what retail investors may experience.

Table 1:

On average, these stocks experienced a 24% price increase on the first day of trading compared to the security underwriters pricing (the offer price), helping to support the excitement associated with high-profile IPOs. However, the stock price declined by an average of 1.4% on the first day when compared to the day's opening price as shown in Figure 1. This is more aligned with what individual investors could experience trying to buy shares on the first day. 

Figure 1:

In addition, these stocks, on average, underperformed the S&P 500 over the subsequent three-month period, as the IPO companies declined 2.8% on average while the S&P 500 increased 3%. This underperformance persisted over the first year of trading, as shown in Figure 2, suggesting that the short-term IPO enthusiasm does not necessarily translate into longer-term outperformance.

Figure 2:

Higher Volatility Potential

IPO stock prices can be extremely volatile and are often impacted by structural characteristics such as a small float, lock-up periods, and limited operating histories.

• The headline market capitalization is simply the share price multiplied by total shares outstanding, while the float-adjusted market capitalization reflects only the shares actually available to public investors after excluding founder, insider, and other strategic or control holdings (such as private equity, venture investors, or sovereign wealth funds). That distinction matters because price movements are driven by the tradable supply of shares. A company can debut at a $1 trillion+ valuation yet float only 5%-10% of its shares, resulting in a relatively small number of shares available for trading and potentially amplifying price swings.
• Pre-IPO investors, such as private equity and venture capital firms, often have lock-up periods and are restricted from selling shares for a period of time. However, when the lock-up expires, early investors may exit positions to get a return on their investments, putting pressure on the stock price.
• IPO companies have limited public operating histories, which makes it more difficult for investors to assess long-term financial performance. As a result, shares can react strongly to earnings reports, changes in growth expectations, guidance revisions, and shifts in broader market outlooks.

Figure 3 shows the volatility, as measured by the standard deviation of the stock prices, of the largest IPOs in Table 1. During the first year of trading, these IPOs had volatility considerably higher than our long-term expectation for the S&P 500 standard deviation. Because of added uncertainty, IPOs often warrant extra caution until valuation can be assessed against fundamentals and profitability is clearer. Given the potential price volatility, investors should carefully evaluate individual investment objectives, time horizons, and risk tolerances.

Figure 3:

Be Aware of These Key Considerations: First Days of Trading

If, after considering the price risk and volatility associated with IPOs at the outset of public trading, you decide to still purchase the stock, it's important to understand how pricing and trading mechanics can affect what you pay and how the stock may behave.

1. Opening price may be very different from the official IPO price. New issues can experience extreme volatility in the first few hours and days of trading in the secondary market. When the company's stock opens for secondary trading and becomes more widely available for individual investors, price swings can be large. In addition, new issues often do not begin trading at the moment the market opens. As a result, the price available to investors may be meaningfully higher or lower than the official IPO price.
2. Market orders are not accepted for an IPO; Limit orders must be used. Edward Jones typically does not accept orders until after the IPO has been priced. Limit orders are generally accepted the morning the new issue is scheduled to be released using the highest price the client is willing to pay in the secondary market. Keep in mind that if the stock does not trade at or below your limit price, your order will not be filled.

Investing Versus Speculating

Large IPOs can come with a lot of fanfare. But in the early days of public trading, it can be difficult to separate long-term fundamentals from short-term momentum. Brand recognition or product familiarity alone is not a sufficient reason to invest. Before purchasing shares, consider the company's business prospects, competitive position, and valuation. If the track record of the company and its management is limited or if the company is not yet generating profits, buying shares may involve a higher degree of speculation rather than long-term investment discipline. While the allure of buying into a new publicly traded company is exciting, it is important that investors maintain a long-term perspective and focus on investments that align with their objectives and risk tolerance.