Is your IPO rightly valued?

Before considering investing in an IPO it is important for investors to understand what IPOs are and how they work.

Is your IPO rightly valued?

Before considering to invest in an initial public offer or IPO of a compnay, it is important for investors to understand what IPOs are and how they work. IPO is a process where a private company, for the very first time, offers to sell its shares for money. The company does this by listing their shares on the stock market and inviting public investors to buy them. It can be a turning point in the life of the company. The money raised can help them accelerate growth and enter new markets, launch new products and attract fresh talent. 

Where to begin?

In the year 2018, there were some 69 companies raising Rs. 27,900 crore through IPOs. 

The very first step to any kind of successful investing is RESEARCH. But unfortunately, most investors base their decisions on hearsay and rumours. Sure, it is possible to get lucky – but relying on luck is risky. So, if you are serious about investing in IPOs you must do your research and analyse all information at hand. The best source of information on any IPO is its prospectus.

The prospectus is a lengthy document and browsing through can get cumbersome. But the key is to understand the relevant parts. 

Related: Equity Mutual Funds vs Stocks: Where to invest? 

An IPO could be expected to command a premium if

a. Backed by a robust business house or management

Look for a company that has been backed by a well-known and established domestic or foreign business house that has created investor wealth. 

For example – HDFC Ltd, Gruh Finance and HDFC Bank have created investor wealth over a period of time. Therefore, one could consider investing in IPOs of HDFC AMC and HDFC Life. 

Try to gather as much information as possible on the CEO, CFO and COO. Do they have a compelling vision? What kind of philosophy to they follow? Their setbacks?

Read up on the Board of Directors. A larger percentage of them should be independent (not related to the owner of the company) and should have worked in other publicly listed companies.

b. Is launched by a business which has been running for many years:

Has the company been making profit for some years now? If not, tread with caution. Avoid businesses that are yet to start up or unproven. 

Tata Consultancy Services, one of the best performing stocks in the Indian share markets, had a history of profits before launching its IPO.

Related: Investing in Money markets vs capital markets 

c. Proven foreign collaborator has picked up stake 

By the time Motherson Sumi had got listed in the Bombay Stock Exchange in 1993, it already had a joint venture with Sumimoto Wiring Systems for seven years. The Sumimoto Corporation was incorporated in 1919 and is a part of the Sumimoto Group which can trace its origins to the 17th century. If you had invested Rs 100 in purchasing Motherson Sumi stocks in 1993, your investment would have more than Rs 3 lakh as on today.

d. Quality mutual funds have invested

Look for investing in IPOs which pique the interest of large institutional investors like credible Mutual Funds. If they are good enough for professional managers they can be good enough for individual investors. Individual investors can figure this out by keeping an eye out for the list of anchor investors in a particular IPO. Sometimes, few of the anchor investors also turn out to be AMCs. Although this information is usually available just a day or two prior to the IPO, therefore a retail investor would need to set a Google Alert or search for the latest news even a day prior to the IPO.

An IPO may be overvalued if

a. Private Equity /Venture Capital investor are exiting

Another important indicator is if the private equity investors are exiting the company at the time of the IPO. It implies that they don’t believe in the bright future prospects of the company. Also, investors.

b. Financial ratios are higher than peers

Financials can be overwhelming but ratios make it easier to understand valuations. Try to draw a comparison of the new company with its peers. Look at the various ratios like Price/Earnings, Price/Sales, Return on equity etc. and compare them with publicly-listed companies in the same space. Avoid if the peers are trading at a much lower valuation than the company.

c. Use of proceeds will be largely redirected towards clearing debt

If a large portion of the proceeds from the IPO (or money raised) is being used to repay debt then there won’t be much left for the company to expand. Evaluate the need for money or whether it’s been used to pay off the insiders.

d. There is substantial hype 

If you feel the extensive marketing activities are creating an artificial hype for the company, stay away. Patience is key. Wait for the stock price to reach a reasonable value and then invest. HDFC AMC Ltd was available at a fair discount within a month of its listing. 

Related: Choosing between fixed-income and market-linked investment avenues 

To sum up

People often misunderstand IPOs as a guaranteed road to riches. Truth be told - IPOs are just like any other investment: there is always risk. You have to consider all the factors and do a thorough research. Time and practice make research and analysis easier. 

Invest in companies whose businesses are easier to understand. Use your knowledge as an investor. 

Investing in an internet company? Spend time on its website. A restaurant chain? Make sure you dine there first. Focus on the key factors mentioned above. Perform scuttlebutt by interacting with distributors, customers and vendors.

A challenging market environment may cause stock price to fall in the near term. But if the management is sincere and business is robust, then average your buying price. In the end, you will emerge as a profitable investor.

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or tax or legal advice. You should separately obtain independent advice when making decisions in these areas.

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