There was a lot of hue and cry about a recent IPO listing in social media and how lakhs of investors lost money in the IPO after the listing happened at a discount and the share continued to slide further later in the day. Most people apply in IPOs without doing proper research and for reasons as absurd as these – oh, there is a good premium in the gray market, it’s a well-known brand and everyone is talking about how big the IPO is, my stock broker has recommended this IPO, so on and so forth.
Here’re a few things that you should look for before applying for an IPO and the odds of success based on your own research will be far better than randomly applying for IPOs.
Objective of the IPO – When a company goes public, they have to submit Red Herrings Prospectus (also known as DRHP) to the SEBI. This prospectus contains all the details about the offering. Before applying for an IPO, one should take a good look at DRHP and try to understand as much as possible about the offering. One thing to look out for is the objective of the issue as to what the company plans to do with the funds being raised from the offering. If the prime objective of the offering is to grow and expand their business further, it usually is a big positive for the offering. Other reasons could include paying for the existing debt of the company (not a good sign), providing an exit to the early investors (although there are certain mandates around this but this can’t be the sole or primary objective of the offering), etc.
Financials of the Company – Needless to say that understanding the financials of the company is important as it tells about the current financial health and future prospects for the company. Questions that you should be asking is, whether the company is profit making or not? If it’s a loss-making company, when do its promoters expect it to turn profitable? What kind of growth company anticipates in future? How is the offering’s pricing fared – overvalued or undervalued. Here’s how you can figure out what the company’s valuation looks like.
EPS Ratio (Earnings Per Share) = Company’s profit divided by its outstanding shares
P/E Ratio (Price to Earning Ratio) = Share price divided by EPS
PEG Ratio (Price to Earnings to Growth Ratio) = P/E divided by EPS Growth
Although it’s quite common to use the P/E ratio to determine the valuation i.e. the higher the P/E ratio, the overvalued it is and vice versa, but P/E ratio alone might not give us the true picture. It could be very high because of the past and future growth of the company on which it is given the desired valuation. On the other hand, PEG ratio can be considered to be a good indicator of the stock’s true valuation. The Lower the PEG ratio, the undervalued it is and vice versa.
Understanding the business and associated risks – Another thing to look out for is the company’s business model. When you read that DRHP, you’d know what the company does, how the outlook of that business looks in the long run and what are some of the risks associated with the business. If you can’t comprehend the company business, it’s better to avoid that offering.
Company Management and Background – “The organization is, above all, social. It is people.” – Peter Drucker. It’s important to do good research on who runs the business, after all they are the ones taking the most important decisions for the company. You can look at things like time spent with the company, past performance, industry experience, etc.
Peer Comparison – Compare the company’s financials, past growth, future prospects, etc with that of its peers. Look how its close peers fared in the past and how their share price did in the long run. Also check the valuation of the offering compared to its peers, if it looks much overvalued compared to its peers, it can be avoided.
Long story short, in a bull market like the one we are in right now, barring a few most IPOs would make money. But things are not always as good and just like the secondary market, primary market too comes with its own set of risks. It is important to understand the business as a whole, figure out on your own whether the offering presents a healthy outlook in the future and then decide on applying for an IPO based on your own research. This way, you will have a better success rate – Good Luck!
(By Ashish Gupta, a delta-neutral volatility-based option trader)