How to Evaluate Sexy and Often Dangerous Tech IPOs

Earlier this week, I shared with Money Morning readers a breakdown on how IPOs are priced.

In this IPO pricing overview, Money Morning Capital Wave Strategist Shah Gilani explained the pitfalls of over- and underpricing an IPO.

An overpriced IPO can be a death sentence for a company, generating bad PR, a stock that bombs, and more. Facebook's (NASDAQ:FB) IPO disaster is a prime example of IPO overpricing.

If underpriced, the company can lose out on raising a larger share of capital.

Today, I'd like to specifically address pricing and investing in tech IPOs, for two reasons:

Number one, tech IPOs are particularly sexy.

These are companies with fascinating innovations, crazy hype, and major potential to pop for investors.

For these reasons, tech IPOs can stand apart from other IPOs when it comes to investing.

And number two, we just so happen to have a fantastic resource on the subject - Money Morning's own Defense and Tech Specialist Michael A. Robinson.

Michael is a Pulitzer Prize-nominated writer and reporter with a 30-year track record as a leading tech analyst.

As you can imagine, he has a lot of knowledge on point and is poised and ready to help our readers.

So, I sat down with Michael and picked his brain on how tech IPOs go about the pricing process, and how investors should approach these investing temptresses.

Here's everything you need to know about how these new issues are priced - plus Michael's #1 Rule for Investing in Tech IPOs.

Pricing and Investing in Tech IPOs: Tips from Michael Robinson

On the valuation process, Michael says, "Tech IPOs are very difficult to price because these companies have a lot of intangibles and a ton of sex appeal. By that, I mean these are classic growth firms that may be adding new sales of more than 50% a year, but have inconsistent earnings as they spend on entering new markets, R&D, product improvements, hiring and more."

Unlike a lot of other industries, tech is oftentimes in uncharted waters...

For instance, the data available to bookrunners or lead underwriters for pricing an IPO in the construction industry is more vast and consistent than is the data on a brand new technology or market.

On top of intangibles, the tech IPO might need more revenue before it can even contemplate reaching its end goal:

"In the case of biotechs, for example, many early stage firms will go public to raise capital for additional research, and to come up with funds to advance products to the next stage. They may be sitting on a breakout drug but have basically no real sales or earnings. So, pricing them is as much art as it is science, so to speak," Michael said.

But not all tech firms are so laden with intangibles.

There are companies in the high-tech arena with a proven track record of success.

"[Some] firms generally have products that have been on the market for some time now, and have gone through several rounds of venture capital," Michael points out. "So, they have a track record that has passed muster with some of the brightest financial and tech minds around."

Even so, the standard pricing metrics, like price to earnings, sales or book ratios remain difficult to pin down.

And the younger tech firms tend to trade at a premium to the market.

"It's not unusual for a sexy, fast mover to have a price-to-earnings of 40 - almost three times the market average. It's because they have a lot of earnings growth ahead and investors want a part of that money stream," Michael noted.

One interesting trend Michael noted is the tendency for tech firms to issue IPOs after having had a stream of losses.

It seems a bit counterintuitive, because who would want to invest in an IPO that is unprofitable?

But the companies probably do this because they need to raise the money necessary to expand sales and build markets, which will generate future profits. Once capital comes in, the IPO might soar.

And this is precisely where the investment bankers come in.

"Here is where the investment bankers earn their money by demonstrating to investors that a price range is justified by growth, quality products, and most important barriers to entry," Michael said.

It's also where investors need to be smart about picking the right tech IPOs to bankroll.

Michael and I laughed as we discussed his IPO investing process. He has rules about investing in tech IPOs that he strictly lives by, but never put a name to before.

They are Robinson's Rules for Buying Tech IPOs. Michael animatedly explained his steadfast method for buying IPOs.

These are the rules he lives by, without exception, in his own words:

"You take the upper range of the expected trade and add 10% to that. Pay NO MORE than that small premium," Michael highlighted. "Otherwise, you can get killed if the stock opens on huge volume and is up 50% in early trading, only to fade late in the day and end up 25%."

"Now then," he continued, "A 25% pop is a successful IPO, but if your market order crosses at the high of the day, you are off to a very bad start. Better to let this rocket ship go and try to catch it later when the froth has subsided."

Increase your awareness on how IPOs are priced by checking out this article, where Money Morning's Capital Wave Strategist Shah Gilani gives his two cents...