While people often rush to buy initial public offerings when the markets are optimistic, there’s a lot more that merits due consideration than simply company popularity
When markets are buoyant or are just returning to normalcy post a slowdown, there’s a beeline to buy IPOs of companies that show good potential for the future, or those with an enviable track record of resilience. While the rush to buy is often viewed as a fairly good indicator of where the economy is heading, there’s a need to exercise discretion while selecting the IPO. Understanding of market dynamics and knowledge of the company’s sector are crucial while picking up the IPO. Here are some of the key points that investors need to keep in mind for selecting initial public offerings best suited for them.
Get crucial insights
Before investing in any IPO, browsing through the web for information on the company, its past performance indices, reviews, market position, future vision, fluidity, liability etc is the basic homework that will provide knowledge and even help in the task of shortlisting a few companies. Though it’s an arduous and time-consuming task, there’s nothing better than doing your own research and digging beyond the headlines to make an informed decision. Most companies have a prospectus that contains a synopsis of everything that needs to be known. A basic fact-finding after reading the prospectus will allow you to verify the findings before investing in IPO.
In the case of unlisted shares, it’s often advised to go for the company that has an established brokerage or while going for smaller ones, choose them very carefully. Determining the valuation of a company is quite a difficult process and the underwriter often bases it on the returns and the company structuring. Comparing the IPO valuation with any of listed shares in the secondary market, can help clear the picture.
Keep a watch on IPOs
It’s almost proverbial wisdom in stock trading that for every share that yields lucrative returns, there are almost equal numbers that turn out to be damp squibs. While the reason for their underperformance can be complex and due to multiple factors rather than a single one, the catch is that it’s definitely not an uncommon scenario. Market valuation can be overestimated to restrict gains in the future. Many times, investment bankers who underwrite a particular IPO make keep it exclusively for selected buyers via mutual funds. This means that most individual investors won’t be able to access the IPO till it gains currency in the secondary markets. Not keeping all the eggs in one basket is another time-tested wisdom that most vouch for in the stock market as well. It is a relatively safer and better option to invest in a diverse and broad range of stocks rather than all new release IPOs.
There are multiple strategies that can be employed for investment. If the IPO shares are unavailable at the offer price, many investors refrain from buying them on the day of listing. If all goes as per market trends and you trust your hunch, then even buying the share after a steep fall, may not be a bad option at all. Another approach is the simple wait & watch till the market performance of the company and whether its thriving is visible enough to make a decision. For risk-averse investors, choosing low-cost exchange and traded funds offers the advantage of both reducing risk and enhancing diversity.
Devil lies in details
It’s often said that what’s apparent may be misleading when the intricate details come in the spotlight. Reading the draft red herring prospectus (DRHP) is the way to grasp all these essential details that often go amiss in simplified headlines or takeaway format news. As per SEBI (Securities and Exchange Board of India), it is mandatory for all companies that want to issue IPOs to release the DRHP. It provides all the relevant financial information about the company and also other key information. Though at first glance, the document may appear dense and boring, there’s no alternative to it when it comes to first-hand knowing about the company’s past, growth avenues, management structuring, founders, vision, challenges, top management, market reputation.
Companies release their IPOs for generating investments that may help them with innovation, market consolidation and expansion. But there may be other less-obvious reasons as well that are sometimes important to get a wind of. At least 20% IPO of a company has to be held by the promoters, though those of bigger companies set aside more. A brief overview of the promoters’ business interests, past ventures, forays and future ambitions, may turn out to be quite revealing. For instance, if the promoters are divesting their stakes substantially, it’s an indicator that things may go downhill and they are just beginning to withdraw. Another possibility could be preparing to side-line the company and devote one’s energies towards newer ventures.
Top management leaders in companies are usually given stock options. If the company is going for an abrupt restructuring and significantly making itself public at the same time, then what the top guys are doing with the stocks needs to be watched out for.
Company’s allocation of money raised
The way a company would utilize the money raised through IPO is detailed in the red herring prospectus. How and where it is allocating the funds and for what reasons, is often viewed as a litmus test of the direction where it’s heading and whether or not it has plans to continue a long-term momentum. Some of the highly-sought IPOs are of companies where the proceeds will go towards cutting-edge innovation, advanced technology, building a footprint in emerging markets, expanding production, diversification, or acquisition of another enterprise. These investments are mainly intended to boost the company’s revenue, growth and make it a bigger name. On the other hand, there are companies that release IPOs to settle old litigations, repay pending debts, or make capital investments not bound to register higher growth.
Whether an IPO is being offered at throwaway price, competitive rate, or it’s hugely overpriced depends on a lot of factors, including the company’s popularity, outreach, market reputation and brand name. A company that’s a household name will have a lot of potential IPO buyers and thus its stock price can be inflated. Fair price of a stock can be determined through competitor analysis. There are two ways of doing this: price-to-sales analysis and price-to-earnings analysis. The first one can be calculated by dividing the price of stock by its per share sale, and the second one can be determined by dividing the stock price by net income per share. Both of these data are also there in the company’s income statement. If both of these ratios are higher than market competitors, then there are high chances that the stock is overpriced. Though it can also be that the company is outstanding as compared to its market competitors, so the share would naturally be priced higher.
Selecting the right IPO among the countless options available may appear to be quite a difficult task for a starter, but following basic steps like a thorough research, sectoral analysis of the company is done and points like pricing, company profile, plans ahead and ambitions, is a considerable help in making the right decisions. For investing in IPO there are no short-cuts and patience, perseverance, and knowledge is the only way.