Last month's Facebook IPO made me realize that investors don't always understand what IPO means. So this month's article is designed to shed some light on the topic.

What is an IPO?
IPO is the short form for Initial Public Offering. It is the process of transforming from a privately held firm, into a public company.

IPO means that the company's owners are willing to offer their shares to the
buying public, for a pre-determined price. This is a way for them to also raise money that may be required for them to expand their company and may be a cheaper alternative then
getting financing through a bank.

Those who purchase the IPO shares become shareholders of the new publicly traded company.

How does an IPO work?
To do an IPO, a company must hire an investment dealer to act as its underwriter. What does an underwriter do? Well, one of their main roles is to help determine the initial price for the stock. They look at the company's balance sheet, revenue, growth projections, etc. and then arrive at what they feel is a reasonable valuation for the company's worth. That's when the IPO price is set. Next, the underwriter files all the appropriate paperwork (such as a preliminary prospectus) with the various securities regulators, and then acts as the distributor for the initial IPO shares that are offered to investors. The underwriter collects a fee for these services to the company.

Who gets IPO shares?
IPO shares are usually offered to institutional investors first, before being offered to retail investors. Golden Girl Finance gives a great explanation for this: "Institutional investors are like frequent flyers - they get shuttled ahead to the front of the line and given valued customer treatment because of the high volume and frequency with which they trade. As a retail investor, stuck in economy class, you get to follow along afterward."

NOTE: Only participating brokers (also know as underwriters) have shares available to distribute. It is also important to understand that even if a brokerage firm is participating, that doesn't mean they have enough shares for all investors. For example, if an underwriter has 2 million shares, but the demand from investors is 4 million shares, then half the investors will be disappointed. Sometimes, a lottery takes place to see which investors will receive the IPO shares. It's not always fairly distributed.

In the case of Facebook, NOT a single Canadian broker was participating. Therefore, we did NOT have any IPO shares to offer our clients. The underwriters for Facebook were all American. This meant that for the average retail Canadian investor, the only way to purchase Facebook stock was to have an investment account with a US broker, or buy it on NASDAQ on the first day of trading.

What is a "New Issue"?
After the initial IPO, a company may decide it would like to raise more money by issuing more "new" shares. Since it is already a publicly traded company, any additional shares it brings to the market cannot be called IPO, but must be referred to as a New Issue (of stock). This is also the term used for an issue of bonds or preferred shares from an existing public company.

First day of trading
There is a big misconception that the first time IPO shares trade on a stock exchange (TSX, NASDAQ, or NYSE), they will be trading at the IPO price. Sorry to burst your bubble, but it doesn't work that way.

For example, Facebook's IPO price was set at U$38. Every investor that received IPO shares would have paid that price. They also avoided paying any commissions for acquiring the IPO shares.

However, on the opening day of trading, Facebook opened at a price of U$42.05. Throughout the day, the shares traded as high as U$45 and as low as U$38. They ended up closing the day at U$38.23.

A Canadian investor wanting to purchase shares of Facebook on May 18th, 2012, could have paid anywhere between U$38 and U$45 on that first day of trading. That investor also had to buy the shares in US dollars (which means doing a currency conversion) and would have paid a commission upon purchase.

Be careful
If you are able to get shares in a "hot" IPO, I usually recommend that you "flip" your shares - which means sell them on Day One. Make a quick profit and get out.

Very sought after IPO shares may initially "pop" up, but will eventually settle down to a valuation that is reflective of the company's worth. The hype surrounding an IPO can make people do crazy things, like purchase stock at ridiculously high valuations. This is when emotions take over. So step away and make logical decisions once the hype calms down.

Stocks can even trade below IPO price. According to an article in Canadian Business magazine, finance professor Jay Ritter performed a study on 1006 IPO's from 1988 to 1993, and found that 3 years after their IPO's, 46% of the stocks were below their initial IPO price. If that happens, and you really like the company, then this may be a more logical time to purchase shares.

Always ask your advisor for an opinion before making a purchase!

Other memorable IPOs

*Groupon (2011)

*Prada (2011)

*General Motors (2010)

*Dollarama (2009)

*Lululemon (2007)

*Tim Hortons (2006)

*Google (August 2004)

*Martha Stewart

*Living Omnimedia (1999)

Further explanation
For more info on how an IPO works, check out this video link:
www.investopedia.com/video/play/initial-public-offering

Final words
Several companies have filed preliminary documents indicating that they are planning to go public later this
year.

The next big IPO might be Coty (who's portfolio includes brand names like Calvin Klein, Sally Hansen, Kenneth Cole, GUESS, and more), or Michaels (the art and craft store). Even the motor-sports franchise Formula One Group is planning an IPO for 2012.

However, even though they plan to go public, expect some high-profile IPOs to either be pulled or delayed due to a slump in investor sentiment or renewed fears over the ongoing debt crisis in the euro-zone.

Again, Golden Girl Finance offers a great analogy: "IPOs can be a lot like hot trends hitting the stores right now: There's a stampede to get them and then, just as suddenly, no one dares to be seen in them."

Only time will tell whether a company is worth its IPO price, but as Warren Buffett says: "a good stock is a good
stock, no matter when you buy it."

Stay wealthy, Natalie.