Initial Public Offerings (IPOs) have been a popular investment avenue. A number of companies have been able to generate listing gains as well as continue to show strong financial performance. At the same time there have been IPOs which have failed to meet investors’ expectations.
The key to success in IPOs lies in the fundamental analysis of the underlying business. While the basic premise of the IPO analysis remains same as in any other company, the key challenge in IPOs remains due to limited availability of information and background of the promoters. So, how to analyse IPOs?
Whether it is a good or a mediocre IPO simply depends upon three factors: Firstly, how the business has performed; second, valuation; and third, promoters’ background.
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A business which has strong underlying strength would reflect this in its financials. Typical characteristics of a good company are strong brand name and multiple successful products, diversified client base and strategically located capacities. A company which has captured business opportunities in its category would have strong market share and this would be reflected in its financial performance and the numbers won’t lie if the business is doing well. A strong business would have good return ratios and efficient capital allocation.
For IPO analysis, one must also check if the company’s financials are consistent with its peers. If they are better or worse than peers, one must find out the reason behind it by analysing volume and realisations, capacity utilisations, asset turnover ratios, etc.
A strong ability to distribute and market its products is a good indication that the business is scalable. Nobody wants to invest in an IPO if the business is not scalable. While IPOs largely provide historical financials, one must find out if a company has good future plans, whether it is adding extra capacity or is developing a new product pipeline.
Historical numbers are best indicator of the management’s capability to scale the business to new heights. Higher realisation, improving efficiency, efficient utilisation of capital, consistently improving return ratios, and increasing market share, etc. are indicator of an ambitious and good management team.
One must also check whether the company has been able to generate strong operating cash flows. A business reporting good sales growth but not able to generate operating cash flows would require further scrutiny. Also, a business which has high capex or working capital requirement must have a strong balance sheet, or it will continually require funds and in the process take high debt or dilute too much equity, both of which are not good for shareholders.
A company with a strong business will catch investor attention, which brings us to the most important part of IPO analysis, i.e., valuation. A business with a good track record, consistent financial performance and good ROE would be a good company but too high a valuation would spoil the returns in the near term. A premium valuation would need strong fundamentals such as margins and return ratios better than peers, strong balance sheet with low debt and higher efficiency ratios and efficiently management working capital.
The writer is senior equity research analyst, Angel Broking