Initial public offering (IPO) is the first stock sale by a company to the public through exchanges. In 2015, a total of 58 companies raised a sum of Rs 90 billion through the IPO route till date. By tracking the IPO history in the last couple of years, one could observe that it consists of both successes and failures. So, investors need to understand the nuances of IPO before taking a final decision.
Why do firms go public?
There are various reasons why a company goes for an IPO. Each company has its own ideal debt and equity ratio or capital structure. One of the reasons why a firm goes for public issue is that it wishes to reach its optimal capital structure to keep its cost of capital minimal. Second is that of price discovery for their equity shares. Also, going for IPO increases the liquidity of the shares. Apart from the above, firms raise funds through IPO for expansion, diversification, acquisitions, etc.
Read the prospectus
The Red Herring Prospectus (RHP) is the document that a company files with Securities Exchange Board of India (Sebi). It consists of everything and anything about the company which has happened in the past or is going to happen as projected by the company. It provides vast information ranging from the date of incorporation of the company, description of its core business, risks factors involved in the business, regulatory landscape, prevailing economic environment, etc. One should read the RHP in depth and look for minute details. Often, investors ignore reading the same whereas it is meant for the prospective shareholders.
Assess the future performance
The very basic point to be kept in mind is that the price that you pay today for a share in IPO is always for the company’s future performance. To assess the same one need to look at the past performance so that you can make an estimate about how well the company is going to perform in the forthcoming years and what is the return you can expect as an equity shareholder. If company performance is good, you can expect a high gain as the stock market will reward your firm by capital appreciation else market will punish the company and you would suffer loss.
Read management discussion and analysis
It is essential to read the management’s discussion and analysis portion given in the RHP wherein management’s perspective on the company’s financial condition, changes in financial condition and results of operations are given.
This narrative section provide investors with information to help them understand how and why the company’s financial results have changed over the time period covered by the financial statements and factors that management thinks might affect the company’s future financial condition or operating results.
Look at promoters and board
Another important point to be noted is that of the promoters, board of directors and other key managerial personnel of the company. You need to ensure that whether the promoter and promoter group is known for their business acumen. Further, one should look at the credentials of the members of the board of directors, their academic back ground and expertise in the business. It is also necessary to check the shareholding pattern in the company by different parties such as promoters, government and public sector undertakings. Generally, a higher holding by these parties indicate a good signal.
Refer the IPO grading
It is mandatory for all companies, which float an IPO, to get their IPO graded by at least one credit rating agency. So, IPO grading is another indicator to assess the company. Generally, a grading of 4 out of 5 is considered good. However, sometimes even good companies withdraw their IPO owing to public sentiments, financial market conditions, etc. in spite of good IPO grading.
Investing in IPOs is similar to investing in any other share but the only difference is that IPO firm’s share is not currently trading in the market. So, investors should look at the market conditions, sentiments and fundamental of the company apart from the above discussed points.
The writer is associate professor of finance & accounting, IIM Shillong