Are Initial Public Offerings (IPOs) Worth It?

This year's high-profile initial public offerings (IPOs) of "hectocorns"—startup companies valued at $100 billion or more—have reignited investor interest in IPOs. Eligible investors hoping to get in on the ground floor of the next big stock generally can buy a limited number of IPO shares at the offering price through their brokerage before public trading begins.

However, the long-term data for IPOs is far less impressive, with the stocks often underperforming the broader market.

We sat down with Jay R. Ritter, emeritus professor at Warrington College of Business at the University of Florida and director of the school's IPO Initiative—a leading source of IPO research, statistics, and trends—to discuss what to look for when considering investing in an IPO.

Jay: Sales. If you're looking at first-day returns alone, companies with less than $100 million in pre-IPO sales have tended to outperform those with higher sales.

However, looking at average three-year returns, companies with pre-IPO sales of $100 million or more have roughly kept up with the broader market, whereas those with sales below that threshold have far underperformed.

If you think about it, this long-term disparity makes eminent sense. Companies that haven't achieved much commercial success are less likely to be a good investment over time, while those with established revenue are better positioned to maintain relatively strong performance.

Companies with less than $100 million in pre-IPO sales have consistently failed to outperform—let alone keep pace with—the market over time.

Jay: Valuation is a big one. My research has found that, on average, IPOs with price-to-sales ratios [PSRs] of greater than 10 perform worse over the long term than those with lower valuations. That's especially true for companies going public with a PSR of more than 40, which must get a lot of things right to justify their lofty valuations. Sometimes they're successful, but generally their longer-term returns tend to be disappointing.

While high valuations signal confidence, the market's biggest entrants face the toughest road to sustained growth.

Jay: The market has certainly changed a lot over the past 45 years. In the 1980s and 1990s, IPOs were much more accessible to individual investors, and companies typically went public at a fairly young age.

In the last 25 years, however, institutional investors have come to represent a much larger share of IPO buyers, and they're much more discerning in the types of firms they're willing to support. They have less appetite for lower-revenue firms, which I think helps explain why companies have been staying private longer. The bigger investors are asking, If you're so great, what's the rush to go public versus having another round of venture capital financing?

Jay: Partly because some of those companies have done very well, even if it's taken a while. You'll remember in the movie Forrest Gump, the titular character made a fortune after Apple Computer went public in 1980. But actually, Apple underperformed the market during its first 22 years as a public company. Only much later did it become a big success.

People have this fantasy about getting in on the ground floor, but for companies that have gone on to achieve long-term success, almost all the gains have come in the years after the IPO. Google [now Alphabet] grew from a $28 billion valuation at the end of its first day trading as a public company in August 2004 to more than $4 trillion now. Nvidia went from $600 million after its January 1999 IPO to over $4 trillion now.

You don't have to get in on the IPO to still potentially profit from a company's success.