IPOs: How to Kick the Tires

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"If you can find both those things, those are the two key ingredients for driving strong earnings growth," he says.

Davis, who was the first CEO of Lycos and now specializes in digital media and Internet companies, says it's important to thoroughly analyze the subsegments within such a broadly defined industry as digital media so as to fully appreciate what a company actually does and who its competitors are.

He asks lots of questions. For example, if a company is the dominant player in a market, what are the barriers to entry for newcomers? If there's another entrenched competitor, does that company have more capital, more time, more resources, more relationships, more intellectual property, or a better team that will put your company at a disadvantage?

In looking at products, he asks "What is the satisfaction that I'm delivering to a customer, that says either 'I'm going to solve your problem or make you feel pretty good about something'?" Having products that give a customer a reason to want to do business with or switch to a provider is critical, he says.

2. Valuation

Renaissance Capital, which does extensive research on IPOs, says its analysts use a variety of metrics to compare newly public firms with the most comparable publicly traded peers. These metrics include price-to-sales, price-to-earnings, and enterprise value-to-cash flow, using the midpoint of the proposed offer's price range. Similarly, Renaissance measures the trading performance of the new company's peers relative to the market, using it as a proxy for the expected trading of the new company's stock.

In weighing the potential value of a company, Morningstar doesn't believe in relying on comparable multiples within the same industry, as many analysts do. Instead, "we build a discounted-cash-flow model based on what we think its competitive position is," says Hodel. "We don't take a favorable view of an IPO just because it's in a hot sector. We take a look at it for its own merits."

In the absence of public filings of financial results and analysts' coverage, investors' best bet is to check the S-1, the registration statement companies are required to file with the Securities & Exchange Commission prior to an IPO. An S-1 typically includes a preliminary prospectus, income statement, and balance sheet, plus various sections that highlight potential risks and intended use of proceeds from an IPO.

3. Corporate Governance

In looking at how closely the interests of the company's managers and the board of directors are aligned with the interests of new public shareholders, Renaissance considers insiders' stock holdings, any conflicts of interests, and the number of independent directors on the board.

An insider on a board often gets paid an exorbitant fee. If a board member has "a relationship with the company through affiliates, then they're not independent and we're not certain they're going to do what's best for investors," says Bard at Renaissance. Insider transactions with an affiliate that may not have been done on an arm's-length basis, such as with a supplier, also set off alarms.

How eager insiders are to sell their shares may also send a warning. If the preliminary prospectus says that founders and officers are selling 30% or more of the number of shares being offered, it could signal a rush for the exits, says author Tom Taulli in his book, Investing in IPOs, Version 2.0.

4. Motivation

Hodel says he likes to see a company with a motivation to do an IPO for reasons other than the strength of recent valuations. "If it's just a cash-out for insiders, that's a bad sign."

A good example is MasterCard (MA), which went public in May, 2006. Some of the banks that owned MasterCard saw a public offering as a way to take some of the litigation risk associated with antitrust lawsuits off themselves.