Indications and the Visa IPO

Visa IPOed yesterday at $59.50 after the initial investors paid $44.00 for their initial holdings. While there is a significant amount of coverage following the IPO, there has been little discussion on how to trade in IPO in general. This was the first major IPO that I've had the luxury to trade, but I have followed many in the past and traders at work spent all week talking about the major initial public offerings in the past five years and how they traded them.

An IPO is the primary offering of equity in a company that will be listed on an exchange. The company sells shares in its company in order to raise capital for future expansion. The difficult part of the process is determining the number of shares to offer and the price at which they should be sold. It is the job of investment bankers to determine the interest in the shares and get a sense of how many should be offered and at what price. They also perform due diligence on the company to determine an estimate the company's value. The difficult part is that the company does not trade actively so not only is the valuation subjective, but there is almost no objective way to confirm if the valuation is correct or not until the offering itself. Several methods are used to estimate the value. The IBankers could use a comparable multiples approach which values the company similar to the market valuation of other companies in the same industry. A discounted cash flow model will estimate the value based on forecasts of future earnings. Finally, the IBankers can compare recent IPOs to the present one; if marketwatch.com's IPO does well, you would expect thestreet.com's IPO to do well also.

For the trader who does not have access to the Investment Banker with the original distribution of shares, there is an opportunity to take advantage of a relative difference in the Banker's valuation and the market's valuation. Philosophically, value is only subjective and the value of a company can be considered only subjective. The market price of shares and the market value of a company is determined by the subjective opinions of the marginal investors (who happen to be the largest market participants like institutions and hedge funds). So the question is, how does the trader determine when the marginal beliefs are out of line with valuation provided by the investment bankers?

Before stocks open, they give an indication of interest if there is a significant discontinuity. This indication is in the form of a bid and offer prices based on opening orders already submitted. If there is going to be a gap up or down on an IPO, it will be shown on the indications prior to when the stock opens. Major IPOs typically are underpriced by at least 30-50% according to the traders I work with. To determine if there is going to be a large jump in the IPO price, listen (or watch) for the indications to keep hitting the offer. On the Nymex IPO, the offer kept getting hit many points above the IPO price. This lead traders to put in more orders to bid the price up further. When Nymex opened, it jumped something like 30 points (from the opening price, but significantly more from the IPO price) until the offer was no longer hit by the bidders (the price got too steep and buying interest no longer kept up with the selling interest). A market order at that time would have faced at least a point of slippage, but a substantial gain nonetheless with no down ticks going up 30 points. In other words, each 100 shares earned 3000 dollars.

On the Visa IPO, I looked for indications to drastically increase similar to what I had heard about the Nymex IPO. At 9:45, there was a bid/ask indication of 52.50 to 57.50, up from the IPO price of 44. I considered this a good sign and then saw the next indication of 55-60 at 9:52. I expected another indication at roughly 10. When this indication did not come, I reduced my size and changed my orders to market OPG (at the open). After a significantly longer gap where I was hoping for another indication, the stock eventually opened at 59.50. I considered this a particularly weak opening and exited my position almost instantaneously at the opening price. Visa hovered briefly around the figure and a small number of shares ended up getting bid in the 60s, but over the next hour, the stock went down to 55 (a possible buy point since the bid indication was at 55, but it easily could have sunk further).

Visa rallied later in the day, but the quick profits to be made on IPOs are getting the price the IBankers offer and taking advantage of the mispricing. Even a 400 million float wasn't enough to result in some mispricing, but there was almost no jump after the open which you would have known had you paid careful attention to what the indications were telling.