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Back to basics – what is an IPO?

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20/01/2014
2014 has been dubbed the year of the IPO. We guide you through all you need to know about stock market listings.

The UK initial public offering (IPO) market enjoyed a recovery last year, with the London Stock Exchange reporting a six-year high in new listings.

A total of £15.7bn was raised through 105 businesses going public, a record number since 2007, according to figures.

Stock market listings by the likes of Facebook and Twitter lent a bit of glamour to proceedings, and investor interest was further piqued by hugely publicised listings including Royal Mail’s flotation.

Now 2014 has been dubbed as the year of the IPO, with big names like Just Eat, Pets at Home and Poundland set to go public.

In preparation, we guide you through all you need to know about IPOs.

What is an IPO?

An initial public offering or IPO is when shares of a company are put up for sale for the very first time to the public.

An IPO is also referred to as ‘going public’ or ‘floating’ – meaning the company is no longer a private company and can be freely traded on stock markets.

What is the difference between a public and private company?

Companies generally fall into two categories – private and public.

A private company tends to have fewer shareholders and the owners generally do not to have to disclose information about the company. Most small businesses are privately held but some big names that are still private include IKEA, Virgin Atlantic and high street giant, John Lewis.

Public companies typically have to file quarterly earnings updates and are accountable to their shareholders.

Why does a company go public?

There are several reasons a company may choose to go public – but often it does so to raise additional funds, to provide better liquidity for its shareholders and to raise brand awareness.

Who regulates IPOs?

All listings of securities in the UK are regulated by the Financial Conduct Authority (FCA).

Are there any tax advantages in investing in IPOs?

That depends on whether you choose to hold the new shares within a tax wrapper like an Individual Savings Account (ISA) or within a Self-Invested Personal Pension (SIPP).

How does a business go public and how can a private investor get involved?

The process outlined below comes from TD Direct Investing:

• The company or business hoping to float will appoint one or more investment banks to act as sponsors, book runners and underwriters. The investment bankers contact institutions to place shares and appoint intermediary retail brokers to act for private investors.

• The Announcement of the Intention to Float (AITF) is then officially made, which will contain the highlights of what the offer will consist of.

• The company also has to decide how many shares it will offer and what the initial price range will be. This determines the company’s initial value when it comes to market, called its market capitalisation. Investors should use this information to decide on whether the shares will make a viable investment. Remember: the price will reflect the expectation of future earnings potential, i.e. investment attractiveness. In other words, the price is driven by the future return investors would expect to receive on their investment.

• This is known as the price/earnings (P/E) ratio and is expressed as the earnings per share (EPS) – a key benchmark of company performance. The higher the potential future earnings, the more attractive the shares will be to buy.

• Investors should note however that it is rare that a firm fixed price for the IPO will be announced in advance. Instead it is common to announce the expected price range, to make forecasting easier before demand is established through actual customer orders. As the number of shares to be issued is fixed so the corresponding price (and hence the initial market value of the company) tends to be fixed only at the end of this offer period, and once it is being traded the price will “float” just like any other share. This is known as an Offer for Subscription.

• The prospectus is essential reading for every investor and they are strongly advised to ensure they are familiar with it and understand its contents before placing any order for the shares. It will be made freely available by all participating brokers.

• Offer period. This is also known as the book building period and generally lasts for around two weeks, during which investors can place their order with their broker for the IPO shares. When making an application they will still not know with certainty what the final share price will be or whether they will get all the shares they apply for.

• Investors should note that offer periods may close early if there is high demand, so it is better to order early if they do decide to invest.

 

• Investors will need to put their order through a broker, and make sure they have a relevant cash amount in their account before the order is placed to prevent any delays.

• Some brokers may close their own order book slightly ahead of the offer period deadline to allow for processing of all orders in time for the first day of trading.

• Investors have the option of putting the IPO shares into a tax wrapper such as an ISA.

• Most retail IPOs will set a minimum order size, possibly in the range as low as £500-£1,000 to ensure smaller investors have the opportunity to participate. Most IPOs do not stipulate a maximum size.

• If the offer is oversubscribed, investors might not be able to buy all the shares they want – this is known as being scaled back.

• Also, check for any minimum holding periods, sometimes referred to as “Lock Up”.

• Once the allotment is finalised, investors’ allotted order and the correct amount of cash will be exchanged for the shares at their final price and will then be placed in their account by their broker ready for the first day of trading on the exchange, which is known as strike day.

• Sometimes the trading of the new shares created from the IPO occurs in two parts. There may firstly be a period of conditional dealing for a few days, which has deferred settlement. Any trades during this period are still conditional on the security being listed on the Exchange and so can only settle once this has been achieved and trading becomes unconditional. Shares bought under conditional dealing cannot be bought within an ISA or SIPP under current HMRC tax rules.

• Unconditional full trading is when the IPO share becomes just like any other share and dealing is said to be unconditional on a stock exchange.

Investors who want a more in-depth explanation of the IPO process, click here.

What are the risks of investing in an IPO?

If you are DIY investor, you will have to use your own judgement and investing skills to decide whether or not to invest in a specific IPO.

While deciding on whether or not to put your money into the IPO, take a careful look at how much risk you are willing to take on, your investment goals, how long you expect to hold the investment for and what you are looking for from the investment – income or growth.

Make sure you read the prospectus carefully to gain as much knowledge and understanding that you can to help you decide whether to make an investment in it or not.

New share issues are potentially volatile, and no matter how big the name – you can see your investment go through big periods of volatility.

Take for example what happened when Facebook floated in 2012. The social media giant floated under much publicity, at a whopping $38 dollars but went onto experience serious volatility.

It was another year and half before the shares cost $38 dollars again.

However in the case of Royal Mail, investor demand and the lower than expected IPO price meant the shares shot up after the shares hit full trading. In fact, the shares have continued to gain steadily.

Investors are reminded that you should only invest what you are prepared to lose and note that holding individual stocks tend to pose bigger risks to portfolios than a fund, which by nature is more diverse.

 

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