Initial Public Offering (IPO)

IPO (initial public offering) is when a private company sells its shares to the public and gets traded on the stock exchange. This process involves investment bankers, lawyers, accountants, regulatory bodies, the board and the CEO. It usually takes a 6 months to 1 year. Here are the essential steps that take place.

1. Internal decision and preparation - the company's board of directors must first decide to go public. It then hires the services of investment bankers, financial advisers, auditors & lawyers to guide them in the process
2. Due diligence and preparation of documents - external auditors come in to assess the company's financial compliance to regulations. A prospectus is prepared by the company's management team (with collaborative help), outlining the company's business model, its current condition, risks (market competition, over-reliance on just a few customers and suppliers, on-going development might take too long or fail, looming problems on the horizon, market acceptance of new technology, liquidity, and debt levels), strategy, and its financials. This prospectus is presented to potential investors (more often, institutional investors). The investment bankers (underwriters), lawyers and accountants conduct a thorough investigation to identify the company's risks and scrutinize legal compliance to regulatory bodies
3. Filing with the SEC - the company files the necessary forms to the regulatory bodies like the SEC. This includes the prospectus and financial statements. The regulators study the filing and recommend amendments or ask additional information. The company resubmits. This can be a back-and-forth process until approved.
4. Roadshow and marketing - the management team and the investment bankers embark on a roadshow marketing presentation to institutional investors (mutual funds, pension funds, insurance companies, hedge funds) and make a pitch on the investment opportunity. The institutional investors make a non-binding bid. This helps the investment bankers prepare a book of demands by the institutional investors to determine how many stocks to offer and at what price.
5. Pricing and final preparation - after the roadshow and getting investor feedback, the final IPO price is settled based on company valuation, market demand and prevailing market conditions. The investment bankers allocate shares for the institutional and retail investors based on subscription levels. They are able to buy these shares at IPO price usually a day before it is listed.
6. Listing and trading - the company stock is listed on the preferred stock exchange (Nasdaq, S&P, NYSE) and a listing day is determined and announced. On the listing day, the public begins to trade on the stock and the price fluctuates depending on supply and demand.
7. Post-IPO - in the early days post-IPO, investment bankers may buy back shares from the open market (not from specific investors) to stabilize the stock from volatility. If the price is falling, they buy back shares to create demand and stabilize the price at the IPO price. When stock price spikes, they sell more shares to lower it down back to IPO level (price appreciation long-term is good for the company but a price spike immediately after IPO leads to a crash and can erode market confidence). This is done only within the first 30 days. A lock-up period of 90-180 days is imposed preventing insiders and pre-IPO investors from selling their shares. Institutional investors are usually not included in the lock-up period. As a publicly traded company, it now has to make periodic reporting in compliance to legal requirements and corporate governance

When a private company goes public, the founder and the board lose control and are now subject to periodic reporting and compliance to regulaltory bodies. Why would they want to go public? What are the reasons?

1. Access to working capital - going public raises a significant amount of money for the company which it can use for acquisition, expansion, defense, etc.
   e.g. In Pixar's case, it went public to raise capital to regonitate with Disney to be an equal partner in all subsequent movies
2. Liquidity for the private shareholders - these could be the founders, early investors and employees who were given stock optons. It's easier for them selling their stocks in the stock exchanges than to sell their shares as a private company
3. Branding - a company listed in the exchanges has increased visibility enhancing its image to its customers
4. Credibility - a public company has more credibility because it's now subject to greater public scrutiny. This enhances its stature to its customers, partners and supplies
5. Attracting and retaining talent - stock options or equity-based compensation is an enticing lure to attract and keep top-level people
6. Currency for acquisitions - instead of using cash, the company can use its shares to acquire or merge with other companies
   e.g. when Disney bought Pixar, it was through its shares, not cash
7. Shareholder diversification - instead of concentrating wealth in one company, shareholders can now diversity through stock sale. This reduces their exposure to just one company and can spread their risks across many companies
8. Valuation transparency - a public company's financial records (balance sheets income statement) are available for public scrutiny. This makes it easier to negotiate with creditors, suppliers and acquirers. This is also useful for management, shareholders and investors
9. Accountability and governance - public corporations are subject to stricter government regulations which instill 'good behavior' by management. The board is also made accountable to its shareholders
10. Exit strategy - venture capitalist, private equity firms, and early investors may have invested for the purpose of cashing out when the company goes public

Going public has its 'downside' as well - loss of control by the founders, tighter government restrictions and regulations, subject to public speculation (like short sellers).

In the few days after the IPO, the stock price might spike up. How to differentiate if the stock price surge was a bubble or just strong confidence in the company?

ChatGPT (in my own words)
A stock price spike after an IPO could be speculative investing to artificially drive the stock price up, then dumped for profit taking. Or, as in the case of Apple going public, the stock price immediately soared due to consumer confidence in the continued growth of the company. These 2 scenarios can be differentiated as follows:

1. Fundamentals vs speculation - if the company's fundamentals are strong (high revenues, profitability, competitive position, innovation, and market leadership) then investor confidence is high that the company will continue to grow, so they invest and may cause a price spike. This was true to Apple and Amazon.
   
   However, if there is nothing impressive about the fundamentals and yet the stock price is soaring, then it's probably speculative buying for a 'buy and dump' scheme or being unrealistically hopeful the price will contunue soaring. This happened in the late 1990s with the dot.com bubble. Companies like Nortel that never made a cent saw its stock price rise continuously....until the bubble burst.
2. Price Earings ratio (P/E ratio) - price divided by earnings per share is a good indicator if the stock is overvalued or undervalued. This depends on industry averages. In the tech sector, P/E ratio of 20-40 is average. Young innovative companies like early-Tesla or early-Apple exceeded 100 P/E ratio. However, mature companies like IBM would typically have 15-25 P/E ratio. Different industries have different P/E ratio averages - auto has 8-15 (due to capital outlay).
3. Revenue and Earnings growth - continued growth in revenues and earnings are an indication of strong fundamentals which could result in a price spike. Netflix and Tesla would be good examples. Otherwise, the price spike could just be speculation
4. Market hype - sometimes, due to hype created by social media, aggressive marketing and celebrity endorsements, a stock price may spike. If there is no underlying growth in earnings or innovation, then it's all hype and liable to burst at some point
5. Industry growth - if the company is well-poised in an industry experiencing rapid growth, then its stock price goes up well together with other companies in the same industry. In the tech industry, when cloud-computing became a viable innovation, tech stocks rose. However, an industry could also experience frenzied buying but the companies were not making money - this was true of the dot.com bubble. It eventually burst and high-flying companies like Nortel crashed and became worthless
6. Investor behavior - if long-term investors like institutional investors are accumulating stocks, then it's a good sign of potential growth. Warren Buffet's Berkshire Hathaway is known for its wise investments and long-term hold. If they buy a particular stock, that stock may spike. However, if there are rapid buy/sell activities on a stock by retailers or traders, it might be pure speculation
7. Corrections and volatility - a strong company with good fundamentals in a healthy market may experience a price drop, but it's usually temporary and the price rebounds back to its proper place. However, if there was speculative buying with no sound fundamentals, when this stock declines, it's usually a rapid nose-dive and recovery take a much longer time or never

Determining whether a stock price surge is a bubble or a reflection of strong confidence in the company is a nuanced process that the market typically assesses over time. While the immediate price increase may look similar in both cases, several key factors help differentiate between a speculative bubble and sustainable growth based on fundamentals.

Here's how the market evaluates whether a price surge is a bubble or legitimate confidence in the company's potential:

1. Fundamentals vs. Speculation: - Sustainable Growth (Confidence): A stock surge driven by strong fundamentals - such as robust revenue growth, profitability, innovation, market leadership, and a strong competitive position - is generally considered sustainable. Investors believe the company's underlying business is healthy, and future growth prospects justify the higher stock price.
   
   Example: Companies like Apple and Amazon have seen long-term stock price appreciation supported by increasing revenues, profits, and dominance in their industries.
   
   Bubble (Speculation): If the stock price is rising rapidly without an improvement in the company's underlying fundamentals (e.g., revenue, earnings, cash flow), the price surge is more likely driven by speculative buying. In this case, investors are betting on the stock price rising further rather than basing their decisions on the company's intrinsic value.
   
   Example: The dot-com bubble of the late 1990s saw many internet stocks surge despite weak or non-existent earnings, driven by hype and unrealistic growth expectations.
2. Price-to-Earnings (P/E) Ratio: - The P/E ratio is a widely used valuation metric that compares a company's stock price to its earnings per share (EPS). If a company's P/E ratio is extremely high compared to its peers or historical averages, it could indicate that the stock is overvalued.
   
   High but Justified P/E: A high P/E ratio might be justified if investors expect significant future growth in earnings. For example, high-growth companies in emerging industries (like tech) often trade at high P/E ratios because investors believe their earnings will expand rapidly.
   
   Bubble P/E: If the P/E ratio is excessively high and there's little evidence of future earnings to justify that price, it may signal a speculative bubble.
   
   Example: In the late 1990s, companies like Pets.com had incredibly high valuations relative to their earnings (or lack thereof), reflecting speculative buying rather than sound investment logic.
3. Revenue and Earnings Growth: - Strong Confidence: If the company demonstrates consistent revenue and earnings growth that aligns with or exceeds market expectations, it supports the notion that the price surge is due to genuine market confidence.
   
   Bubble: When a company's stock price soars without a corresponding increase in revenue, profits, or market share, it could be a sign that the surge is based on unfounded optimism or speculation rather than business performance.
   
   Example: Companies like Netflix or Tesla have seen dramatic stock price increases over time, but those were supported by consistent growth in revenue, market share, and business expansion, justifying the market's confidence.
4. Market Sentiment and Hype: - Strong Confidence: When price increases are based on rational market sentiment, supported by positive earnings reports, product innovations, or industry leadership, it's a sign of legitimate confidence.
   
   Bubble: In a bubble scenario, price surges are often fueled by excessive media hype, fear of missing out (FOMO), and speculative behavior. Investors may chase stock prices higher, not because of fundamentals, but because they believe others will buy at higher prices. This can create a self-reinforcing cycle until the bubble bursts.
   
   Example: The GameStop short squeeze in early 2021 is an example of speculative buying driven by market hype rather than company fundamentals. Prices surged due to retail investor enthusiasm, social media hype, and a short squeeze, rather than confidence in GameStop's long-term business prospects.
5. Industry Context: - If the company operates in a growing industry with solid long-term prospects, a price surge may reflect broader market optimism about the sector. For example, in the late 2000s and 2010s, tech companies like Google and Amazon saw their stock prices rise significantly as investors became increasingly confident in the growth of the internet, cloud computing, and e-commerce sectors.
   
   Bubble: If the entire industry is experiencing a speculative frenzy, with companies being valued far beyond their actual business potential, it could point to a bubble. This happened during the dot-com bubble, where many internet companies had sky-high valuations despite weak business models.
6. Investor Behavior: - Strong Confidence: Long-term investors, including institutional investors, generally look for stocks where they can achieve sustainable growth. If these investors are accumulating shares steadily and holding them for long periods, it's usually a sign of confidence in the company's long-term prospects.
   
   Bubble: In a bubble, there's often short-term, speculative buying by retail investors or traders trying to capitalize on quick price movements. If you see large volumes of trading with frequent buying and selling, it can signal that investors are more focused on price momentum than the company's fundamentals.
7. Corrections and Volatility: - Strong Confidence: In a healthy market, a stock price may fluctuate, but if it's supported by fundamentals, any corrections (price drops) tend to be moderate and the stock rebounds over time based on company performance.
   
   Bubble: When a bubble bursts, the stock price experiences a sharp, rapid decline. Bubbles often lead to extreme volatility, where the price crashes because investors realize that the stock's value was inflated and not supported by the company's performance.

Given all the above procedures before a stock is sold to the public, Steve Jobs, when he needed more financing for Pixar, valued his company at $30M from thin air and offered 10% of the company for $3M to venture capitalists - no takers. In a few weeks, he revalued his company at $126M by selling Ross Perot 16% of Pixar for $20M. This he did without the management team or any investment banker - but this was pre-IPO for Pixar.