6 Ways to Vet an IPO Before You Buy

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In the aftermath of the Facebook initial public offering (IPO), the web has experienced a deluge of answers to the question “What went wrong?” What happens when one of the most hyped tech IPOs in recent history doesn’t rise to meet investor expectations?

For months I’ve been advising family and friends against buying Facebook. The reasons were fairly simple. I felt the entire IPO was a matter of style over substance, with little data to back up long-term revenue growth and earnings potential. It was also entirely possible the value of Facebook had peaked, and the IPO was a way for Facebook executives to reap the rewards of the company’s riches before an earnings decline. I felt Morgan Stanley, the firm underwriting the IPO, didn’t understand how Facebook worked and certainly didn’t understand the company. (In fact, rumor has it that over a year ago Morgan Stanley executives had to hire Zuckerberg to give a private tutoring session on how to navigate Facebook.) Hundreds of analysts more experienced and smarter than I am had a different perspective. Advice from media outlets came in droves, promising us the "biggest IPO ever." Amidst all the frenzy, it became hard to distinguish the public image of Facebook from the public offering being presented.

Perhaps the sagest advice came from PIMCO’s CEO and co-CIO Mohamed A. El-Erian on the Huffington Post, who remarked, “…the manner that our brains have evolved and work may not always result in the best investment decisions.”

Instead of asking “What went wrong?” a better question for investors to ask might be “How can we prevent this from happening again?” Here are five ways to vet an IPO before you buy. (See also: 5 Killer Free Investment Tools)

1. Check the SEC S-1 Form

All companies are required to file what is called a Form S-1 with the Securities and Exchange Commission (SEC) before an IPO goes into effect. Facebook’s can be found on the SEC.gov website.

The S-1 will contain the meat of the information on a company. It’s not exactly light reading, but it will have important data that’s well worth a look. Not only does an S-1 contain information on the offering price of the company and estimated par value of the stock, but facts and figures on a company’s business plan, long-term growth objectives, and estimated budget. There’s a wealth of information to be had on an S-1 form, and it should be considered a “must read” before any responsible investor even considers purchasing an IPO.

2. Read the Corporate Earnings Report

Companies typically have a portion of their website for "Investor Relations." Browse carefully, and you should be able to find detailed financial information, often called Quarterly Reports or Annual Reports. Financial statements can provide detailed information on current cash flow and revenue, but more importantly for IPOs, projected cash flow and revenue. Facebook's Investor Relations area can be found on their investor subsite.

3. Consider the Underwriter

The firm underwriting the IPO serves several purposes. It prepares a valuation report of the company to be offered and helps to correctly determine the share price. This is usually a big investment firm. In Facebook's case, Morgan Stanley was the underwriter.

When considering an IPO, scan the S-1 for mention of the underwriter and ask yourself a few questions. Is it a reputable firm? Do they have a history of accurately pricing IPOs? Do they stand to profit from the success or failure of an IPO?

4. Get Second Opinions

It's human nature to want to be told we're right. But when it comes to investments, try to get a second opinion and listen to people who disagree with you, just to consider an opposing scenario. Listening to other points of view might spark new questions you hadn't thought about, or might confirm your previous opinion. Either way, gather information from a variety of sources to use as informational tools in decision making.

5. Do a Risk-Benefit Analysis (for Yourself)

Ultimately, buying an initial public offering is always risky. Even the most seemingly stable companies can experience an unexpected setback or glitch that lowers their value after investors have bought into an IPO. A risk-benefit analysis involves weighing the risks and benefits of an investment and determining what is right for your individual situation. Remember that there's no market history on share prices for the company you're about to buy into, no way to glean historical data. The fact is that while most people focus on the "get rich quick" aspects of an IPO, it's just as likely that they will lose money. Be realistic about how much money you are willing to invest, and risk, on an IPO purchase. Will you experience buyer's remorse? Can you stand to lose part of your investment? In other words, don't bet the farm. It's common sense, but you'd be surprised at how many people forget about risk when they think a big payoff might be in the near future.