The Motley Fool : Do your homework before jumping on IPOs

When a company needs money, it has some choices. It can borrow from a bank or wealthy investor, or issue bonds. Another option is to sell off a chunk of itself to the public, via an “initial public offering” (IPO).

Investors often work themselves into a frenzy when a highly regarded company first issues shares of itself on the stock market. This causes the new stock’s price to skyrocket, further fueling the public’s interest in IPOs. Some high-profile IPOs you might remember include those of Netscape in 1995, Amazon.com in 1997, and Google and Mastercard in 2004.

Individual investors like us usually can’t buy shares of “hot” IPOs at their initial prices. For starters, not all brokerages are allocated shares. The big clients of the underwriting investment banks — such as pension funds, mutual funds, other corporations and high-net-worth individuals — generally get a first shot at the shares. (If a broker offers you IPO shares and you’re not a major client, the big players must not have much interest in them, and perhaps you shouldn’t, either.)

There are many reasons to avoid IPOs:

“ They tend to be much more volatile than other stocks.

“ Most are tied to young companies with unproven operating histories. It’s best to let a firm get a few public quarters under its belt before investing.

“ IPOs often underperform.

Though many IPOs do surge in value in their first days, others don’t. The much-hyped high-fliers usually descend, permitting us to buy when the shares are priced closer to their fair value. Consider Burger King, which debuted in May 2006 at $17 before falling to nearly $12 per share within a few months. It’s now back around $18. Shares of Internet phone service provider Vonage fell some 14 percent on their first day (also in May), and are now down roughly 60 percent from their issue price.

There are many promising companies out there with established public track records. Think twice before scrambling to get a piece of an iffy IPO.

Ask the Fool

Q: What makes interest rates rise and fall? — R.K., Richmond, Calif.

A: Interest rates are affected chiefly by inflation and the market for debt (notes, bills, bonds, etc.). With inflation rather low over much of the past decade, we’ve enjoyed low interest rates. (Even after a recent period of rising rates, they’re still relatively low.) But when the economy appears to be growing too briskly, which can spur inflation, the Federal Reserve, now headed by Alan Greenspan’s successor, Ben Bernanke, may hike short-term interest rates via the “federal funds” rate. That’s the rate a bank can charge another bank for use of its excess money. When the economy is sluggish, it might cut rates in order to give American enterprise a boost. Lower rates give companies and people an incentive to borrow (and spend) money.

The Fed can also change the “discount rate” — the rate paid by a bank to borrow short-term funds from the Fed.

The prime rate and other interest rates are based primarily on these two interest rates, while mortgage rates are linked to Treasury bill rates. The money markets themselves (basic supply and demand for money) also exert great influence over interest rates.

Q: When a stock falls and I lose money, where does it go? — L.D., Columbus, Ohio

A: When a company’s stock price declines, nobody necessarily directly benefits from the loss. Imagine you own shares of the Dodgeball Supply Co. (ticker: WHAPP). If shares drop 20 percent one day, you haven’t technically lost any money — unless you sell the stock. The shares are less valuable, though. When a stock tumbles, its value isn’t redistributed. It merely shrinks. As a related example, think of how your car’s value depreciates over time.

My dumbest investment

My dumbest investment ever was buying shares of a small chemical company. It lost 90 percent of its value in less than a year. Remarkably, I made this selection based on an early (and remarkably credible) e-mail “tip.” These are very common now, but it was an early scam in 2001. It was rather stupid of me in retrospect, but it became a valuable life lesson. I did my best to “research” it, but there was little financial transparency. — R.E.V., Danbury, Conn.

The Fool Responds: That’s indeed a great lesson, to turn away if you have trouble finding solid information on a company, such as its financial reports filed with the Securities and Exchange Commission. It’s also smart to ignore e-mailed stock tips. If an investment is so compelling, no one should have to send out e-mails hyping it — especially if it’s an easily manipulated “penny stock,” trading for less than $5 per share. Such e-mailers have often already bought shares for themselves and will sell as soon as conned e-mail recipients drive up the price by also buying.