IPO Trading Strategy – How Do IPOs Perform In The Short And Long Term?

IPOs are one of the most frequent corporate events in the market. They get a lot of press coverage, and it is not unusual to see large pops on the first day of trading. But the question is: how do IPOs perform in the short and long term?

IPOs perform well early, during the first days of the IPO, but tend to underperform in the long run.

In this article, we are going to look at what an IPO is and how it performs in the short, medium, and long term.

Related reading: –9 Reasons Not To Buy An IPO

What is an IPO?

An IPO, or Initial Public Offering, is a significant financial event in which a private company transitions into a publicly traded one by selling its shares to the general public for the first time. This process allows the company to raise capital from a wide range of investors, which can include individuals, institutional investors, and mutual funds. In return, investors receive ownership of the company in the form of shares.

IPOs are often conducted when a company is seeking substantial funds to fuel its growth, repay debts, or provide existing shareholders with an opportunity to cash in on their investments. To initiate an IPO, a company typically hires investment banks and financial advisors to assist with the process. They evaluate the company’s financial health, set an initial share price, and create a prospectus that provides potential investors with information about the company’s business, risks, and financials.

Once the IPO is launched, the company’s shares are traded on a stock exchange, allowing investors to buy and sell them freely. The success of an IPO is often judged by the level of demand for its shares, which can result in increased capital for the company and potential capital gains for early investors. However, how do new investors buying into the IPO tend to perform?

IPO’s Historical Performance

We often read in the newspaper that an IPO stock jumped 20% or 30% on the first day of trading, but is it always like this?

The following chart shows the average gain on the first day a stock starts trading by year since 2005. As you can see, the only negative year was 2008, whereas the best year was 2020.

Source: Statista

Wow, the average first-day performance is really great. But what about the performance in the first year?

The following chart displays the average year-end gains for all U.S. companies that went public.

For example, if a company went public in October, the return is calculated from October through December 31st of the same year. Most IPOs have shown positive performance over the past decade. In 2022, however, the average returns amounted to a negative 55 percent in the first year after their IPOs.

Source: Statista

Moreover, a study done by Nasdaq shows that long-term performance varies significantly, especially over extended time frames. Initially, approximately 50% of companies outperform the market the day after the IPO, with a quarter exceeding or lagging behind by less than 2.5%. This suggests that the IPO price closely aligns with the market valuation on day one.

However, a year later, most companies either significantly outperform or underperform the market by more than 10%. Additionally, more companies underperform than outperform the index. This suggests that some companies may not meet expected earnings, leading investors to reevaluate the IPO and adjust its value to reflect the company’s actual, slower growth.

Source: What Happens To IPO’s In The Long Term? (Nasdaq article)

Lastly, a paper by Jay R. Ritter, published in 1991 and called The Long-Run Performance of Initial Public Offerings, found that the average return for a sample of 1,526 IPOs in 1975-84 was 34.47% in the 3 years after going public.

Did they outperform the market?

No. A control sample of 1,526 listed stocks, matched by industry and market value, produces an average total return of 61.86% over this same 3-year holding period.

To put it differently, when investing a dollar in a portfolio of IPOs acquired at the closing market price on the first day of trading, it yields a terminal wealth of $1.3447, whereas a dollar invested in the matching firms results in $1.6186. In the long term, IPOs demonstrated underperformance.

How do IPOs perform in the short and long term? – conclusion

To sum up, today you learned what an IPO is and what is the process behind it. Moreover, we showed you that IPOs tend to do really well on the first day of trading, and the outperformance seems to diminish as time passes.