4 red flags in IPO’s to watch out for

If and when the 2023 IPO market opens up, here are 4 red flags in IPO’s to watch out for.

An IPO is an exciting investment opportunity for investors, but this excitement doesn’t always translate into a good return. It can be difficult to tell how an IPO will perform on the day of listing, let alone in the years after. But, in our view, there are some key signs investors should look out for in any IPO. And they might have to do significant due diligence of their own.

Signs an IPO might be a good investment

In our view, there are signs that an IPO has potential to be a good investment. First, if it has long-term leadership, particularly in the CEO’s seat. This may be the company’s founder, or it could be an experienced company executive who has steered the ship for a number of years. It is also positive if they have skin in the game, in other words, significant equity ownership.

Another sign is if the company’s valuation is reasonable. By valuation, we are not talking about the raw share price, but total valuation of the company in its own right and compared to its peers. The most useful multiples investors can use are EV/EBITDA and P/E.

Why is a company listing?

When looking for red flags in IPO’s, also look to see why the company says it is listing. If it is to fund growth and investment it may sound good in principle. But investors should look to see if the company is listing to fund a specific acquisition, or if it has set general growth targets for future years that it hopes to achieve.

It is a good sign if a company has a proven track record of executing growth while private.

4 red flags in IPO’s that may indicate a bad investment

In our view, there are four red flags in IPO’s investors should look out for when deciding whether or not to buy into an IPO. First, when Private Equity (PE) and/or founders are cashing out. This is because it is a sign in and of itself that the company cannot grow further. Why would they be selling if they thought it could grow further? To counter this fear, major shareholders may set an escrow period to try and reassure investors. But no escrow period lasts forever. We have seen too many examples of PE funds IPO-ing a company where it didn’t end well for the new shareholders. Virgin Australia could be the next cab of the rank in that sense.

Pumping up the story or too high a valuation

Second, if the company refers to large Total Addressable Markets (TAMs) or compares itself to big names, when the company itself is a small cap. We have seen this a lot with Tech listings on ASX in particular, where investors’ appetite is whetted through name-dropping and the prospects of grabbing a small marketshare in a very large market. A lot of these cases have ended in tears.

A third red flag, and this is an obvious one, is when valuation multiples are too high relative to its own growth and/or its listed peers.

Don’t get caught up in a hot trend

The fourth and last of our red flags in IPO’s is if the company is centered around a ‘hot theme’. Investor Paul Samuelson said that investing should be more like watching paint dry or watching grass grow. In other words, it should not be exciting.

During bull markets, there will be a number of IPOs that are based around ‘hot themes’. These shares may go on a run after IPO, notwithstanding bad fundamentals. But before too long, investors jump off the bandwagon and onto the next ‘hot theme’, leaving everyone else stuck in an illiquid small or microcap.

One example was food delivery stock Youfoodz. It listed at $1.50, but plunged after listing and never recovered. This company ultimately decided to sell itself 7 months after listing for 38% discount to its IPO price.

Look out for red flags

So, if and when the IPO market opens up in earnest over the next 12 months, be mindful of these 4 red flags in IPO’s. Do your homework and ask the obvious questions … why should I buy this stock if the founder or PE is selling? Is the valuation reasonable given the growth prospects of this stock? Is the company BS-ing me with

What are the Best ASX Stocks to invest in right now?

Check our buy/sell tips