IPO 101: Learn the ropes

The Starting Point

The most important point that one should look out for while investing in an IPO is the reason for which the company is entering into the capital market. This information is available under the head ‘Objects of the issue’. When you look at the objects of the issue, you might get a feeling that this company does not actually need to raise funds. This brings us to the first point that when an investor looks at an IPO, he or she needs to address this key question…

Is the company making an IPO and raising funds because it can (on account of a booming market)? or

Is it raising funds because it needs to (on account of a good business opportunity)? If the latter is the case, then more often than not – one has qualitatively superior IPO on hand.

If the company is raising funds because it needs to, the reasons can be expansion, diversification or setting up new projects, but the important thing here that an investor should do is to carry out a due diligence of sorts on the projects mentioned. For example, if a manufacturing company is raising funds to increase its capacity, and the current capacity utilization is low, then the company is just raising funds because it can as it does not need to increase its current capacity but only utilize the current capacity at a higher level. However one should note that in public sector units, in which the government is disinvesting, the object of the issue may not be comparable on above mentioned criteria because the government is shedding its control as a matter of policy or to raise resources for itself.

The Management
The retail investor has the disadvantage of not having any access to the promoters – the people who start a company and then take it public. However, there is a fair amount of information available in the prospectus of the company. The problem is that most people don't bother to read even the abridged prospectus (application form) while investing in an IPO.

Investors should pay more attention on the profile of the management, which is more often than ignored. Thus it will give one a fair idea of where the promoter stands.

Fundamentals/Business Model
After a clear understanding of the ability of the management and the antecedents of its key members, one should look at the business model of the company and the scalability of the same. The industry in which the company operates and the positioning of the company within the same as compared to the competitors merits detailed analysis.

Important factors that one should look for include areas where the company may have an edge over others, for eg the kind of entry barriers and government regulations that prevail in the industry. Thus, the evaluation process is more or less sequential: in the first series of steps one looks at the management, the project, the industry scenario and the business model. Financials and pricing come later.

The Financials
Based on key qualitative factors, the question one needs to answer is whether a company can continue to deliver the kind of earnings per share (EPS) it has delivered in the year before the IPO, especially on the enhanced equity base after the IPO. After the IPO, the number of shares increase significantly, and a company must justify that by earning much more per each share.

Besides this, there would be an entire gamut of financial parameters to be looked at. Among these are the debt-equity ratio, profit margins usually seen in the earnings before interest, taxation, deprecation and amortisation – simply called EBITDA by analysts. The measure of the price as a ratio of the book value (called P/B) and the price as a multiple of the earning per share (called P/E) are key valuation parameters. Whereas there are industry-specific ratios (such as average revenue per user in the telecoms industry) that also come into play, one should place great emphasis on the traditional ratios too, because unlike ratios that are fads of a given time-period, the ones mentioned above have stood the test of time.

The Pricing
In the end, everything boils down to the price. The pricing is really the culmination of the whole process. One cannot look at the pricing totally in isolation and say that 'if the pricing is 'okay, everything else about the issue is 'okay!

It should actually be the other way round. If everything else about the issue is right, then you look at the pricing. One of the common mistakes that merchant bankers make is that they price the IPO so tightly that all the positives get factored in before the issue, rendering the stock vulnerable to sharp downswings once the listing euphoria ends. Ideally, an IPO should be priced cheaper than its comparable listed market peers in order to make the issue attractive. However, in a booming market, promoters and merchant bankers woo gullible investors with aggressive advertisements – which in the end could well be paid for by investors in an indirect manner!

To conclude, one should not get carried away with the amount of hype created for an issue. One should not buy a stock only because it's an IPO – but because it is a good investment and can enhance investor’s wealth in the long term.

(The author heads Lotus Knowlwealth and blogs at www.theipoguru.blogspot.com)