The Value Of An IPO

By Amy E. Feldman

PHILADELPHIA (CBS) - A company's stock price is based on what the market will bear. But on its first day of trading, how do you know?

Turns out that buying stock in King Digital Entertainment PLC, the maker of Candy Crush, wasn't such a sweet deal after all.

The company, which had been privately owned, went public last month and at its initial public offering - the IPO, the date on which the company first sold shares to the public on the stock market - the stock was originally valued at $22.50. By the third day of trading, the stock had dropped 20%, leaving many investors who'd lost their shirts to ask: what the…? How did this happen?

It's one thing if a company has to report bad news and the stock price drops accordingly, but who said the stock should open at $22.50 in the first place and why were they so wrong?

When a company first goes public, it enters a contract with an investment bank, or underwriter, who approaches investors to sell the shares. The underwriters then engage in calculations to figure out the value of the company, and the prices of other comparable companies to set the initial price at which the stock is offered - low enough to get people interested, but not so low that it doesn't raise enough capital or suggests that it isn't a worthwhile purchase.

Sometimes they are off and the market doesn't bite as expected.

If you're an investor, understand the bases on which the stock is valued, the company's sales forecast and know the share prices of other comparable stock before plunking down your cash on a soured investments.