How to spot a bargain IPO

Question: Is it a good idea to buy a company at its IPO? I've heard it's better to wait, but how long?

Answer: As you allude in your question, the oft-cited advice is to let the stock price "settle" after an initial public offering before taking the plunge; institutional investors' trading activity can cause an IPO stock to soar on its first day of trading, but this inflated price might not be sustainable. 

But while it's wise to be aware of these trends, no two companies (and hence no two IPOs) are exactly alike. It pays to take a more nuanced approach to looking at valuation. The best way to avoid overpaying for shares of a hot new IPO is to come up with your own fair value estimate of the company's shares and not pay more than that.

Let's take a closer look at how IPOs' initial prices are determined and some of the forces that shape those prices in the market. Then we'll take a closer look at how Morningstar analysts think about a company's intrinsic value, and we'll see whether we would have been buyers of six prominent IPOs on their first day of trading, or today.

How IPO Pricing Works

Have you ever noticed that after a company's initial IPO price is announced, that initial price might not even come into play at all on the first day of trading? Often the stock opens higher than its initial pricing range. This has to do with how the IPO process works.

A company looking to go public will usually hire an underwriter (or underwriters) such as a large investment bank to help facilitate the process of selling its shares. The underwriters will often restrict the supply of shares for three to six months after the offering to help buoy the price. This means the share price is not always determined by the normal supply and demand of the stock market, at least while the dust settles in the weeks after the offering. Once the price is set, those same institutional clients are the ones who get dibs on the shares at the IPO price.

By the time the shares start trading in the open market (in other words, when smaller individual investors have access to them), the part of the company that was sold off is already in the hands of those sophisticated investors. This means the share price is determined by the normal supply and demand of the stock market, not what the underwriter and the firm set as the initial price.

What's Your Fair Value Estimate?

At Morningstar, we use a discounted cash flow model to come up with a fair value estimate range. Essentially, that means that we think a firm's intrinsic worth, or fair value estimate, is equal to the value of the cash the business can generate in the future. But the cash that is generated today is worth more to investors than the cash could be generated in the future due to the uncertainty that the business will actually deliver those results. And if you give up a dollar today to buy that future cash flow, you have the opportunity costs of using that dollar to invest in other, potentially safer assets. For this reason, we apply a discount rate to those future cash flows to account for these unknowns.

Our estimate of fair value is independent of where the shares are trading in the market, so we value shares of an IPO the same way we value shares of a company that has been trading for years. We think a stock is an attractive buying opportunity when it is trading at a discount to our fair value estimate. Crucial to coming up with a fair value estimate for an IPO is an analysis of the information found in the S-1, a detailed registration statement that the underwriters file with the Securities and Exchange Commission prior to the initial public offering. (Here is Uber's S-1, for example.)

Uber (UBER)

One to Watch

Initial Public Offering: April 18, 2019
Priced at: $45
Opened at: $42
Closed at: $41.57
Debut session loss: 7.6 per cent

Stock analysts Ali Mogharabi and Julie Bhusal Sharma believe that Uber has a narrow economic moat. Its core business, the ride-sharing platform, has displayed some moat sources such as network effects and intangible assets, which could position the firm to become profitable and generate excess returns on invested capital in the future, they said. In addition, Uber has grabbed market share in food delivery very quickly, and we think there is strong growth potential in that.

Based on all available information, our analysts estimate that Uber's per-share fair value estimate is $58, which is nearly 30 per cent above where the stock is trading right now. So, we think Uber's IPO looks attractive, but as with all very high uncertainty names, we would want a healthy margin of safety before jumping on board. Our 5-star price is below $29.

5 IPOs: Would We Have Been Buyers?

Let's take a look at several more IPOs and see whether we would have been buyers on the first day of trading based on our fair value estimates. (In the charts below, the thicker solid line is the stock's daily closing price, and the thin, dotted line is its Morningstar fair value estimate.)

Pinterest (PINS)

PASS

Initial Public Offering: April 18, 2019
Priced at: $19
Opened at: $23.75
Closed at: $24.40
Debut session gain: 28.4 per cent

Pinterest, a social network that allows users to virtually share ideas and products, was initially priced slightly below our fair value estimate of $22, but it opened at $23.75 and has traded above that price ever since. It's currently trading at a price/fair value of 1.30, which we consider overvalued.

Mogharabi believes Pinterest has a narrow economic moat. It displayed a network effect among its users and has begun to compile valuable intangible assets, or user data; we think it can effectively profit from both. We recommend that investors in this very high uncertainty stock should buy with a fairly large margin of safety: Our 5-star price is under $11.

Lyft (LYFT)

PASS

Initial Public Offering: March 29, 2019
Priced at: $72
Opened at: $87.33
Closed at $78.29
Debut session gain: 8.7 per cent

Lyft's IPO price was right in line with our fair value estimate of $72, but on the first day of trading it soared to the $80-range before settling back down to close at $78--a price/fair value ratio of 1.09.

Mogharabi believes Lyft has a narrow economic moat for two reasons. First, there is a network effect between drivers and riders. Second, Lyft has accumulated valuable intangible assets around driver and rider data that will be hard for startups and newcomers in the ride-sharing space to replicate, in Mogharabi's opinion. But even though he's sanguine about Lyft's prospects and the stock price has come down quite a bit since its IPO, Mogharabi still recommends that investors wait for a wider margin of safety before investing in this very high uncertainty name. Our 5-star price for Lyft is below $36.

Snap (SNAP) 

PASS

Initial public offering: March 3, 2017
Priced at: $17
Opened at: $24
Closed at $24.48
Debut session gain: 44 per cent

We would have passed on Snap right out of the gate, as its mid-$20 range was well above our $15 fair value estimate. We wouldn't be interested in it today, either. It's trading about 25 per cent below our fair value estimate of $14, but we would wait for a larger margin of safety with this no-moat, very high uncertainty name. Our 5-star price is $7; the company briefly traded below this threshold when stocks sold off in December 2018.

We think Snap and its users benefit from a network effect among its customer base and is starting to attract the attention (and dollars) of advertisers with a growth trajectory toward $1 billion in revenue. But Mogharabi points out that there is no guarantee that Snap will effectively monetize these users on a consistent basis, and he isn't convinced about the firm's ability to generate excess returns on capital over the next decade.

Facebook (FB)

PASS

Initial public offering: May 18, 2012
Priced at: $38
Opened at: $42
Closed at $38.23
Debut session gain: 0.6 per cent

Upon Facebook's initial public offering at $38 per share on May 18, 2012, we thought the price was overly optimistic. We valued the social network at $32 per share; our price/fair value at the IPO was 1.18.

For much of 2012, the stock was trading below its IPO price. The low of around $18 in September 2012 would have been a great entry point. Of course, hindsight is 20/20, but as you can see from the price/fair value chart below ( also available to Premium Members for all securities), we felt that the stock was trading at a compelling valuation at that time.

We have always maintained that Facebook has a wide moat rating based on network effects around its massive user base and intangible assets consisting of a vast collection of data that users have shared on its various sites and apps. Despite regulatory risks, we have steadily increased our fair value estimate over the past few years as we saw increasing evidence that Facebook has been able to leverage its large audience and valuable data into online advertising revenue. We would wait for a comfortable margin of safety before picking up the shares, though: Our current 5-star price for Facebook is below $120 per share.

Twitter (TWTR)

PASS

Initial public offering: Nov. 8, 2013
Priced at: $26
Opened at: $45.10
Closed at $44.90
Debut session gain: 72.6 per cent

When Twitter's initial public offering was priced, we thought it was fairly valued; we initiated coverage of Twitter at $26 per share. After the price soared nearly 73 per cent in its first day of trading, it was well out of our buy range, however.

As our price/fair value chart indicates, we have become less optimistic about Twitter's prospects over time (as has the market). We recently downgraded our moat rating on the firm to none from narrow; slowing user growth is dimming Twitter's competitive advantages in our opinion. We see the company as overvalued today relative to our $30 fair value estimate.

Karen Wallace, CFP® does not own shares in any of the securities mentioned above.