What is an IPO
An upcoming IPO (Initial Public Offering) refers to the very first set of equity shares that an erstwhile privately-owned business entity throws open to public investors. When a private company decides to go public with an IPO offering, it is normally underwritten by an investment bank or broker that purchases a part of its shares for a pre-decided price. These shares bought by the underwriting entity are then released into the financial market through multiple stock exchanges that allow for investment in IPOs with the sale and purchase of company stocks.
Since they have not been traded on the stock exchange previously, there is no historical performance data available which is usually used for predicting current stability and future growth. Therefore, let us now examine some of the key parameters to be considered before making your decision.
Factors in IPO Analysis:
1. Overview of the market and macroeconomic trends – If you want to invest using fundamental analysis, don’t forget to check out the prospects of the sector which you are investing in and gain industry-specific knowledge to compare different companies in that sector from the market’s perspective. This includes reading up on the laws and regulations relevant to that industry (to make sure the company isn’t too vulnerable to regulatory risk and also to predict future price movements due to regulatory changes).
2. Draft Red Herring Prospectus (DRHP) and further financial research– According to SEBI guidelines, no company can issue IPO stocks if it doesn’t release the DRHP. The prospectus provides in-depth information about the company. It’s the most authentic way to know about the company’s growth prospects, market vision, structuring, founders, reputation etc. The DRHP can be found on SEBI’s website, stock exchanges’ websites, and company websites. Financial performance gives a fair idea whether you should go ahead with the planned IPO investment or not. This prospectus can be a good source of information for prospective investors to carefully comb through the business model and anticipated strategies of the company. Ideally, this should be backed up with online or offline research regarding news, developments, management structure of the company through its website, annual reports, financial statements, media reports, and business magazines. It is important to remember that a prospectus is unlikely to contain any negative information that might be pertinent to your investment decision as it is made by the company itself in association with the merchant bank that is undertaking the IPO investment. So self-research is of great value.One could also check out ratings given to the company by credit rating agencies such as India Ratings, CRISIL and CARE. They provide investment grades for companies preparing to go for IPO. Companies that are faring well financially will usually receive a rating of 4 or 5.
3. Financial valuation ratios – It is imperative for traders to know whether the shares being offered in an upcoming IPO are overvalued, fairly valued or undervalued, based on which the investment strategy should be set. Use formulas like price to earnings ratio, price to book ratio, debt-to-equity and return on equity. They should be looked at not only for individual companies but also from the perspective of portfolio diversification to reduce risk and increase the probability of nice returns.
4. Assess growth prospects – Stock-trading profits depend on growth of companies. Therefore, gauge the future growth potential of the industry in which the company operates (including the related upstream and downstream industries) and assess the possible market share of the company in the coming years. Parameters such as the company’s core business model, its current and future competitors, investment in technology and innovation, market expansion strategies, competitive advantages and its ability to leverage such strengths further can come in handy while assessing the future market share of the company.
5. Management team – In continuation to the above discussed point, while historical performance of the company’s operations may not be so readily available, one can always research the track record of the management team. This is important to gauge whether it is capable enough to steer the helm of the company and the direction they are expected to take. Reading the intentions of the company’s promoters and management is essential to invest in new upcoming IPOs. It is important to understand how much interest the promoters or the management holds in the company before investing in an IPO. In India, the promoters have to abide by certain SEBI-mandated lock-in periods of a minimum share of the total post-issue capital. If the company’s promoters are diluting their stake just upto or even beyond the limits mandated by law, then it is both illegal and also indicates that they have lost faith in the company’s future. Similarly, a company’s management rewarding itself with fat remunerations or huge dividends while diluting its stake before an upcoming IPO should also be considered as a sign of suspicion and it is advisable to stay away from such IPOs. Just like promoters, management honchos are also given stock options. If restructuring is among the purported reasons for IPO, then what the top management is doing with their IPO stocks is also indicative of the company’s direction and future prospects.
6. Verify the intended use of the IPO money – Investing in new technologies, workflow dynamism, quality improvement, entering new markets, acquiring other businesses, improving existing facilities or setting up an additional production facility are usually aimed at the company’s growth. All these growth-propelling investments could soar the company’s revenues resulting in higher stock prices and dividends. It is better to avoid those IPOs that use their proceeds to repay their old debts, settle old claims and legal hassles or just meet working capital requirements. Check why the IPO is being issued, whether it is a Fresh issue or an Offer-for-Sale.
7. Price and dividend – Subsequent to the release of a prospectus, the company is expected to announce the details pertaining to the size of issue and corresponding price band. A price band is the range between the expected ceiling (maximum) and floor (minimum) prices within which the sale of the share will be expected to be conducted. A renowned brand releasing IPO stocks will attract a rush of buyers, thus the stock price can get inflated due to the demand-supply mismatch. The right price of a stock is usually determined by competitor analysis based on brand value, financial strategy etc. The company’s brand value must be read in conjunction with its P/E (Price-to-Earnings) and P/S (Price-to-Sales) ratios to estimate the fair price of its stock through a competitor analysis. If these ratios are higher than those of its competitors, then the stock may be overpriced and thus avoidable. Furthermore, check the company’s dividend policy to be able to compare expected flows of dividends (passive income). Also, preferably invest at the cut-off price. That way your application will be considered, whatever may be the final allotment price.
8. Over-subscription – There are only a limited number of shares that a company offers through the IPO route. The allocations to different categories of investors are also decided well in advance. Often it happens, there are more potential buyers who have applied than the number of shares released. In these cases, you may end up getting fewer IPO stocks that you applied to buy, plus the price may be inflated and fall in the long run. However, purchasing oversubscribed shares in the short run can be a great way to make profits for traders. To be able to access these, you must have a good relationship with your broker so that you may receive these shares before anyone else does. The value of oversubscribed shares will continue to rise as they become available for customers in the open market. This happens because the demand and supply for such shares take some time to equalise.
9. Select a good broker – As we have seen that a minimum amount of research is required for proper research and analysis of the IPO, it is advisable to get a broker who gives reliable advice on which IPO to invest in. Try Angel One, one of India’s most trusted brokers.
10. Measuring interest of institutional investors – Unlike retail buyers, institutional buyers as well as high net worth individuals (HNIs) have the resources at their disposal to perform in-depth research into companies since they are usually putting large amounts of capital into the IPO. As a result, a greater degree of institutional buyer interest in an IPO could be an indicator of a sense of confidence in the IPO by the market. However, this factor must only be used as an indicator, and not the primary reason for investing in an IPO.
11. Use advanced technology – There are various algorithms and engines that can churn out investment recommendations by crunching the numbers. As a retail investor, you may not have access to such technology but you can always take the advice of a qualified investment advisory firm such as Angel One that has specialised teams dedicated to researching stocks and IPOs.
There is no replacement for informed decisions backed by thorough insights. The investor needs to be careful to not get swayed by marketing tactics of companies and retain focus on verifiable facts. Another mistake to be avoided, as per most experts, is to refrain from investing with the primary intent of deriving listing gains. While the IPO might be the talk of the town at the moment and over subscribed multiple times over, it does not necessarily guarantee proportional gains the moment it is listed.
Opening an IPO account with trusted online brokers such as Angel One is hassle-free and allows you to manage your portfolio with zero brokerage, and account maintenance fees.