Investment Insider: Never judge a company flotation by its covers

Ignore that glossy brochure and look at the trading history

In some countries it is known as a flotation. In others it is called an initial public offering or going public. Some simply call it an IPO.

But have you ever thought about what it actually means when a company floats its shares onto the market for the first time?

We know what it isn’t. We know it isn’t some altruistic act by the owners of a company to let you have a piece of their business on the cheap.

Far from it, even though many companies that float on the stock market might claim they want their “members”, “fans” or “customers” to partake in the future growth of the business.

In some cases an IPO is a way of raising additional capital for the business. In other instances, an IPO is simply a way that existing owners can realise their investments by selling a portion of their business.

If you think about it, these owners could just as easily dispose of their stake to a private buyer – and some do.

However, most opt for an IPO even though it is not only costly but also forces a business to disclose information that it could otherwise keep private.

The thing is, an IPO generally allows owners to get a better price for their stake in the business. That is probably why many are choosy about where they launch their flotation.

For instance, a Chinese-based company might achieve a higher valuation if its shares are quoted on say, the Hong Kong or Singapore stock exchanges rather than in London.

It is worth bearing in mind that an IPO is designed to achieve the best-possible price for the existing owners. So if you are interested in buying IPO shares, it is crucial to examine the company’s trading history.

It is also worth looking critically at how much “lipstick” has been applied to the balance sheet to make it appear more acceptable. For instance, has the company’s debt been massaged ahead of the flotation?

In terms of debt it is also worth looking at whether the company is saddled with lots of it. If so, does the company plan to use the proceeds of the flotation to pay down its loans?

Additionally, what else does the company plan to do with the money raised? In other words, how does the company plan to grow the business?

If the proceeds are simply to make the existing owners rich and satisfy creditors, then that would put a totally different complexion on the flotation.

It is also a good idea to look at how much of the business will be owned by management after the IPO.

Ideally, you would want them to have a significant stake in the business. The more they stand to lose, the better it could be for new shareholders.

In most IPOs, the odds are stacked against new investors. Consequently, it is hard to know when a float is overpriced. One way around the problem would be to build into your valuations a wider margin of safety. Alternatively, it may be prudent to wait until after the company has been on the market for a while before buying shares. That is, if you are still interested in buying the shares after the euphoria has subsided. By that time you should have more information to make a better judgement than simply the cover of the IPO’s sales brochure.

David Kuo is director of fool.co.uk