Since Initial public offering (IPO) is the first sale of shares by a company to the public. Here are some steps to identify good and bad IPOs.
Look at company’s past, future
Firms which come to public for an IPO issues the red herring prospectus (RHP), which shows revenue and earnings the company has generated. You should look to see whether the company is profitable and growing. The company also present its projected financial statements along with the risk factors. You should read this carefully and make your own estimation about the projections.
Check promoters holding
As per the law of the land, promoters should have a minimum post-issue stake of 20%. You should scan through the prospectus and check how much is the percentage holding by the promoters post IPO. It is generally preferred to invest in those companies where the promoter and or top management team holds a large position of shares. This can be inferred as a signal that the top management strongly believes in the company’s future.
Use IPO money
The prospectus issued by the company state what the company’s plan to use the money it raises from the IPO. If it uses the cash for its expansion, diversification or activities related to the growth of the company, it is a good idea to invest in those companies. But, if it uses the cash to re-pay its long term loan or in other activity which may not lead to the future growth, it is a good idea to stay away from those IPOs.
Be cautious of over-subscription
Often, you read that a particular IPO is over-subscribed by three times. Don’t get excited about it as many investors assume that if the IPO is over-subscribed, it must be a good investment. This may or may not be true. A company gets capital to grow via bank loans, investments by family members or private investors and private equity firms. Each time the company raises new money, new investors are willing to pay more for the stakes as long as the company is performing well. When a company decides to offer shares to anyone through a public offering, existing shareholders gain a more by selling their shares post listing. Even if the share price drops from the IPO, these investors will receive more than what they invested. This may not necessarily be the case for those investors investing afresh during IPOs.
Do a peer valuation
The most popular method of evaluation of an IPO is through peer valuation. A comparison of the price of an IPO with the share price of its peers which are already trading in the market can give you an idea whether a new offer is overvalued or undervalued. Investors should compare important ratios such as book value, operating margins of the IPO issuing company with those of other companies in the industry which are already listed on the exchange. If the company shows strong fundamentals, one should compare the cost of the IPO with the earnings history and projections. By comparing earnings multiples, one can easily find if a company is undervalued or overvalued.
Don’t aim for flipping
Flipping is reselling an IPO share in the first couple of days to earn a quick profit. Don’t have the motivation to do flipping while subscribing for an IPO. Of course, institutional investors can flip stocks and make big money. In the past, many IPOs that big gains on the listing day come down when institutional investors booked their profits. Those who are looking to make short-term gains should invest in the new offers only when the markets are bullish because the success of an IPO also depends a lot on the market sentiments at the time of listing. One should look at many things when evaluating an IPO’s potential but make sure to check the above points and do your own due diligence before investing in an IPO.
(The writer is associate professor finance & accounting, IIM Shillong)