3 Predictors for Positive IPOs

Your heart aches for Facebook stock, but your brain tells you to stay away from the notoriously volatile world of initial public offerings. Should you listen to your heart, and run away with those young and dynamic shares? Or listen to reason, and stick with well-aged and sensibly priced stocks? There are actually a few characteristics of IPOs that help predict their success, but before those are revealed, let's look at general IPO performance.

The numbers
The first-day performance of IPOs can attract a lot of attention. According to one study, IPOs averaged only a 7% first-day return in the 1980s, but during the tech bubble of 1999 and 2000, first-day returns averaged 65%! Average first-day returns came down to 12% between 2001 and 2003. That's a great one-day return, right? But how about for those of us who are not day traders and who invest for the long term?

The results aren't as favorable. Another study shows that after the initial lockup period, when original investors like employees can sell shares, stock prices dropped 0.05% per day for one year compared to similar firms. As Fool Travis Hoium notes, any IPO investor should be aware of when this lockup period ends.

But on a longer timeline, performance must return to normal, right? Sorry, this same study reports that over three years, this negative abnormal performance totals 22.4%. Suddenly those flashy stocks don't seem as attractive as more mature offerings.

When are IPOs a good idea?
The numbers don't look great, but remember these were average returns. There are definitely potential winners right from the IPO. Take, for example, Google (NAS: GOOG) . Its 2004 IPO started at $85 per share and it has never closed below $100 per share. Google, unlike many IPOs, actually posted profits for three years prior to selling shares. As the New York Fed found in a study, "firms with negative pre-IPO earnings were three times more likely to be dropped from an exchange than were profitable issuing companies."

In the same study, the Fed confirmed that younger companies underperform older companies, and high insider ownership increases the chance of an IPO surviving. So, for example, Groupon (NAS: GRPN) , founded in 2008, had not posted a profit before going public, but does have insider ownership at 34.3%. Groupon presents two negative predictors and one positive one.

Here are a few other recent IPOs:



Profitable in Year Prior to IPO

Insider Ownership at IPO

Pandora (NYS: P) 2005No63.85%
LinkedIn (NYS: LNKD) 2003Yes64.20%
Renren (NYS: RENN) 2002No37.60%

Source: Company prospectuses.

Based on this sample, LinkedIn offers the best option with actually being profitable, but it should be noted that Renren was profitable in past years, just not the year prior to its IPO. And since its IPO, Pandora returned about a 20% loss, at a time when the S&P 500 gained 6%.

The Foolish takeaway
Check any IPO you might be tempted by, like Facebook, against the characteristics above. And remember that you don't have to grab shares the first day. If it's a solid company, there should be plenty of opportunities to become a shareholder.

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At the time this article was published Fool contributor Dan Newman is part of the 10% of the population not on Facebook. Follow him @TMFHelloNewman. The Motley Fool owns shares of Google and LinkedIn. Motley Fool newsletter services have recommended buying shares of Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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