Initial public offerings (IPOs)

Understanding risk in an IPO

When a company decides to offer shares to the public for the first time, it must go through a process known as an initial public offering (IPO), or public float.

Here we explain why a company might go public and things you should consider before investing in an IPO.

What is an IPO?

An IPO or 'float' is where a company offers shares to the public for the first time. The company may want money to grow the business or repay debt, or the founders may want to exit or reduce their investment. Most IPOs involve listing the company on a securities exchange, such as the Australian Securities Exchange (ASX).

How to decide whether to invest in an IPO

The best way to decide if you should invest in an IPO is to read the prospectus. The IPO prospectus must contain key details about the company and the float, and companies need to lodge this with the Australian Securities and Investments Commission (ASIC). 

Smart tip

If a company issues a supplementary or replacement prospectus, check it very carefully. It may be a sign that the original prospectus was inadequate.

The details in the IPO prospectus will include:

  • information about the company, its operations and financial position
  • the number of shares on offer
  • how the money raised will be used
  • how to apply for the shares
  • the risks associated with the offer.

Our prospectuses webpage has more information on what to look for in this important document.

Your IPO checklist

Investing in an IPO can be a difficult decision because there is no market price for the shares (that would show what other people are prepared to pay for them). Also, the business will often not have a track record or will go through significant change as a result of the IPO.

Check the IPO prospectus to answer these questions:

  • Sector - Do you understand the sector the company operates in, or plans to operate in?
  • Competitors - Who are the business' competitors and why does the company think it can compete with them?
  • Financial prospects - Do you understand the financial statements? Have revenues/profits been growing? If the company is not profitable, do you get a clear sense of when (if ever) it might be profitable? Companies at an early stage of development are a much riskier investment proposition.
  • Relative value - What is the price-earnings ratio (P/E ratio) of the company? How does this compare with its competitors? The P/E ratio will help you to get a sense whether the IPO is fairly priced. Generally, a higher P/E ratio means investors expect higher growth.
  • Dividends - Does the company intend to pay a dividend? If so, when is this expected?
  • Purpose of float - How will the company use the funds raised through the IPO?
  • Licences - Does the company have all the necessary licences and permits to operate? If not, when will it get them?
  • Directors - Are the company's directors and managers paid what you would expect for the company's size and industry? Do the directors and managers appear to have appropriate skills and experience? Check that they are not listed on ASIC's Banned and disqualified register. The prospectus should disclose if any of the directors have managed a company that failed in the last few years.
  • Advisers - How much are independent advisers paid as a percentage of the funds raised by the IPO? If the fees exceed 10% then you should consider whether the company's advisers are being fairly remunerated. The more money that goes to advisers, the less that is available to the company.
  • Risks - Is the risk disclosure section detailed and specific to the company? Vague language or general disclosures (such as warning that the price of shares can go down) could be a sign the company is not telling you everything you need to know.

If the answers to any of these questions raise doubt in your mind about the company's prospects, get professional advice before investing. Alternatively, look for an investment you can understand more easily or, if you want to take a chance with the IPO, only invest money you can afford to lose. 

Warning

Some IPOs are highly speculative and the share price can fall quite quickly. For example, a mining company's mineral exploration may not be successful, and smaller companies, particularly from emerging market jurisdictions, can be at an increased risk of failure.

Can you trust financial commentators?

As well as reading the prospectus, you may look for other sources of information to help you decide whether to invest in an IPO. Be careful when relying on recommendations by financial commentators who write for investment newsletters, chatrooms or blogs.

These financial commentators may not be experts in IPOs and may rely on reports from analysts paid by the IPO issuer. In some cases, financial commentary may be discreetly sponsored by the company looking to raise capital. What looks like an independent evaluation may actually be advertising in disguise.

Before you invest, read as widely as possible and learn as much as you can about the industry, the company and its competitors. This will give you the best chance of making an objective decision about whether to invest in the company.

ASIC's role in IPOs

ASIC does not endorse, approve or verify the content of prospectuses, but all prospectuses must be lodged with ASIC before any securities are offered to the public. To check if the issuer has lodged a prospectus, see ASIC's OFFERlist database.

ASIC reviews most prospectuses to assess whether the disclosures appear to comply with the law. However, these assessments are only based on the information provided; ASIC may not know if a company has failed to disclose negative information.

Companies do not have to meet any merit-based criteria to list, they just need to have a minimum number of shareholders and meet an asset or profit test. This can include the money they raise in the IPO.

If you read something in a prospectus that you think is incorrect or misleading, you should not invest until you get a satisfactory explanation in writing or an amended prospectus is issued. You can also make a complaint to ASIC about the prospectus.

Investing in an IPO can be risky, so do plenty of research. If you still have questions you can't find answers to, or if you have any doubts, don't risk your money unless it's an amount you can afford to lose.


Last updated: 03 Apr 2018