…Not everyone can handle so much sugar. This painting is called “Dividend Day at the Bank of England”, by George Elgar Hicks, an English painter. This masterpiece was painted in 1859 and retracts the people waiting to receive its dividends from investing in the Bank of England. If you look close enough,
then you’ll see the following sentence on the wall: “Dividend Office for Consols Reduced Long Annuities & Bank Stock”.
You can see people of all ages. Those with the topper look wealthier. We can also see children with their
families, young and even a man in a wheelchair. There is even a cat on the table, near the bankers, and a dog on the floor. This is a great proof of cats’ superiority over dogs, humans and even aliens. No doubt about it.
Everyone in this photo decided to take some sugar which can be understood as a “risk” on the stock market. When you buy a stock, then you become a business partner. The CEO of Apple will certainly don’t know who you are if you buy one unit of AAPL, but it doesn’t matter.
You’ll be entitled as the owner of 1 over the total of stocks of his company. This doesn’t give you almost anything. You’ll not have any voting power. You’ll not get to choose what path the company will follow. But the beautiful part is that you will be the owner of a small piece of Amazon and every time they sell a book, computer, monitor… a small piece will also be yours.
The only reason you can buy a stock is because an Initial Public Offering (IPO) took place somewhere in time. You can take a look at the latest and upcoming IPOs in this link.
Initial Public Offering (IPO)
(Almost) Every stock starts small in the stock market
Let’s suppose you own a small company like this one:
The rationale behind an IPO
It doesn’t matter what you
are going to sell or how you are going to sell it. The key fact here is: you
will need cash. You can use your savings and that is nice. The company can grow
with your money, but it could grow (much) more with someone else’s money.
So, the first thing you do
is to call your mom and then your dad (there is also an aunt, grandmother,
girlfriend, cousin and so on…) to lend you money to invest in your company.
Probably this will be a tax-free loan depending on how much loved you are.
Companies need cash to make
investments and grow. Your company can achieve a certain level that you will be
able to go to a bank and get an official loan. Banks don’t love you, so this
one won’t be tax-free like the other example and your cash flow will be
pressured. No problem here since your company keeps growing and expanding its
margins.
Let’s use a very simple example to explain how important a loan is to a company.
- $100 of investment generates $120 of profits after 1 year without debt: In this example, the rate of return is 20%. You only have to divide 120 per 100. Simple as that. This means that for each $1 invested, the company generates 20% of profits ($0,20).
- $100 of investment generates $120 of profits after 1 year without 50% of debt at 5% per year: In this example, the rate of return is MUCH HIGHER. Instead of investing $100, you’ll invest $50 (the bank is paying the other $50). At the end of the year, your company will generate $120 but you’ll have to pay $52,50 to the bank (5% of interest over $50). So, you invested $50 to get $67,5. Just do the simple math and you will get a return of 35%.
What do we learn from this?
If a company manages to get healthy loans (those that the company can honor) at
interest rates lower than the company’s growth rates, then its effective growth
will be considerably high.
This is exactly what an IPO
does: it raises money! An Initial Public Offering is a mechanism that allows a
company to go from private to publicly traded. When a company decides to do an
IPO, then it’s telling the investors that some part of the company will be
divided into many pieces called stocks and everyone who holds it will be a
partner in the business (for the good and for the bad).
The shares of the company
must be priced through a rigorous process of due diligence. The investors need
to have access to all of the documentation in order to make a decision about
joining the IPO. If it does, then the
investor will have to make a reservation through its broker of a certain amount
of money and wait until the process is done to receive the information on the
number of stocks and price.
If a private company wants
money, then it will have to ask the banks or a few owners. If a public company
wants money, then it will be possible to issue new stocks (at a lower price
than the current market price) to raise money from shareholders. Instead of
asking the bank, the company will be asking YOU. As I told you before, cheap
money can do miracles.
Past Initial Public Offerings on the Stock Market
The best of the best
According to Reuters, these were the top U.S. IPOs of all time, in terms of valuation:
Figure 1 – TOP U.S. IPOs of all time, in terms of valuation. Source: Reuters
Look at Alibaba (BABA) revenue growth. Being part of an IPO like this one gives you the unique opportunity to own a part of this business:
Figure 2 – BABA Total Revenue – FQ. Source: made by the author using TradingView
The worst of the worst
Even going public, several companies didn’t make their way to glory. Sometimes it takes a while to realize that there was a huge difference between what was written on the business plan and what it could be done. If a company can’t grow and increase its revenues and margins in a way that the market can trust, then its stocks will certainly suffer.
Motley Fool, the well-known firm that offers investment consulting, lists some examples here like eYoys, Pets.com and Groupon. Even though this link refers to 2017, it’s possible to find almost the same companies on newer links, like this one from Coinspeaker entitled “7 Worst IPOs in history”.
Let’s do the same we did with BABA and now look at Groupon’s revenue. It’s really that bad? Yes, it is. See for yourself.
The wolves are out there and they want your money.
Conclusion
A “Blue chip stock like Kodak” is just one of the lies that are hidden in business plans. Kodak was a legend. The company introduced the first commercial transparent roll film in 1889 and ruled for many years the photography market. That “blue chip” stock is history today. Everyone can take a picture with an ordinary phone and the market has changed forever.
IPOs are amazing opportunities to join new companies but they also bring greater risks. It takes a while to realize if the company is really able to deliver its promises. There are hundreds of companies in the stock market that have been delivering consistent profits for decades.
To join a new company investing in its IPO can be highly risky if you don’t fully understand its business but can also be very profitable if you make the right call. There is no right answer to investing in IPOs. It’s all about how much sugar you can take because the real difference between medicine and poison is the dosage. Invest well and be true to your risk profile.