You have probably seen the claim, ‘If you had invested Rs 10 lakh in this company 20 years ago, its value would be in crores today’, floating around social media. And the fear of missing out (FOMO) becomes palpable when everyone seems to be making money in the stock market. However, many jump on the bandwagon without much thought, only to find themselves in financial trouble later.
One common misconception among investors is that Initial Public Offerings (IPOs) guarantee profits. Some believe there’s no risk involved. With the emergence of new-age fintech companies, many of which are yet to turn profitable, getting listed on stock exchanges, it is crucial to separate the winners from the losers. Let’s explore how investors should evaluate IPOs.
When a company seeks to raise funds from the public markets, it must prepare an IPO prospectus with the market regulator, SEBI. This document is a treasure trove of information for investors and should be the starting point for evaluating an IPO. Instead of relying on recommendations from friends or family, investors should meticulously study this document.
Some key sections to focus on include:
Sector and Company Details
The IPO prospectus, also known as the Draft Red Herring Prospectus (DRHP), provides an in-depth analysis of the sector and the company’s operations. It covers macroeconomic factors, sector dynamics, competitiveness, current state, future growth prospects, supply chains, and more. Details about the company’s operations, business segments, geographies, brands, products, joint ventures, subsidiaries, manufacturing plants, promoters, and management are also included. Understanding these aspects provides insight into the company’s operations.
Type of Offer
An IPO typically consists of two components: ‘Offer for Sale’ and ‘Fresh Issue’. In an Offer for Sale, existing shareholders sell their stake to the public, whereas a Fresh Issue involves the company issuing new shares to investors. Investors should prefer a combination of the two or a completely Fresh Issue, as it indicates that the proceeds will benefit the company.
Objectives of the Issue
For the Fresh Issue part of the IPO, investors should understand how the proceeds will be utilised. The prospectus provides a detailed breakdown of the fund allocation, such as debt repayment, working capital financing, or business expansion. This section helps investors understand where their investment will be deployed.
Scrutinising Potential Risks
Investors should carefully assess the risks outlined in the prospectus, including company-specific and macroeconomic risks. Understanding these risks is essential as it highlights potential challenges that the company may face in the future.
Assessing Management Quality
Investors should ensure that the company’s management is competent and trustworthy. Checking for any criminal or legal cases against them and reviewing past management interviews can provide insight. Additionally, investors should pay attention to the auditor’s opinion provided in the prospectus.
Evaluating Financials
Analysing the company’s financials is crucial for assessing its performance. Key metrics such as sales growth, operating profits, after-tax profits, margins, profitability ratios (ROCE/ROE), debt-to-equity ratio, and cash flow should be thoroughly examined. Strong financials indicate a sound company.
Comparison with Peers
Comparing the company with its peers helps investors gauge its relative valuation. If the company is valued higher than its peers, there should be justified reasons for this premium, such as better business fundamentals or unique advantages.
Lastly, investors can refer to the Grey Market Premium (GMP) to gauge the potential listing price of the company’s stock. However, it is essential to remember that the GMP should not be the sole factor for investment decisions, as market sentiments can change.
In conclusion, evaluating IPOs requires a thorough analysis of the prospectus and consideration of various factors. By conducting due diligence, investors can make informed decisions and mitigate risks associated with IPO investments.
*The article is for information purposes only. This is not an investment advice.
*Disclaimer: Teji Mandi Disclaimer
