IPOs: How to Kick the Tires

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"Our analyst looked at the company and determined that the litigation risk was more a matter of perception, that it wasn't as big a deal, as some people thought," says Hodel.

The MasterCard example also highlights the need to peer below the surface of typical market concerns. For example, any mention of litigation risk in a company's S-1 is generally treated as a red flag that shouts "Beware" to would-be investors. Stated risks should be weighed in the context of how big an impediment to growth they may be. If the worries that a risk gives rise to aren't warranted, it can just as easily be an opportunity.

5. Underwriters

Investors would be wise to scrutinize not only the company offering the shares but also the financial institution underwriting the deal. The first question is how confident the underwriter is that there's enough demand for all the shares being offered. If a bank offers shares on a firm commitment basis, it's a sign of confidence in the quality of the stock, while offering to sell shares on a best-efforts basis shows some trepidation.

The size and reputation of the underwriter can also send a signal to investors: "The general rule of thumb is either to stay away from or take a closer look at companies being underwritten by third-tier underwriters that don't typically do IPOs," says Bard. "They don't have as long a track record, but also the companies they're taking public are less-seasoned companies."

One trait that distinguishes the so-called top-tier banks from others is their relationships with the largest institutional investors, such as major mutual fund companies. By using a top-tier underwriter, a company has a better chance of placing its shares with the most reputable institutional investors. But even the best-regarded underwriters do their share of less-than-stellar deals, Bard warns.

Certain underwriters have more expertise in particular sectors, perhaps because they have a trustworthy analyst covering a given industry. Morgan Stanley (MS) and Goldman Sachs (GS) are known for their skill with technology companies, which can serve as a kind of stamp of approval, Bard says.

An IPO may look good on the surface, but the involvement of a second- or third-tier underwriter can make investors suspicious and can cause some of the top institutional investors to hold off and question why a more respected bank isn't managing the IPO, he says.

But a less-well-known underwriter doesn't always mean there's reason for concern. A small shop may have specific knowledge of an industry that makes it more qualified to handle the IPO than a bigger firm.

Morningstar is beginning to take a closer look at the shareholders behind IPOs as another way of gauging a company's underlying value, Hodel explains.

"This is going to be especially important as more private equity firms come public," he predicts. "We're getting a sense of who the better private equity or venture capital firms are [in terms of] how well they pick their investments, how they value them, how disciplined they are in what they pay for them, how well they operate them after taking control of them."

Bogoslaw is a reporter for BusinessWeek's Investing channel.