30-May-2023
Stocks

What to look for before investing in IPOs

To understand investing in Initial Public Offering (IPO), we will explain an incidence from your childhood. This incident is common, and we are pretty sure you may have experienced it too. Do you remember having an old cricket bat or a Barbie doll that you played with for a long period of time and eventually got bored of? Also, the bat or doll started looking old and faded.

One day, out of surprise, your parents gifted you a new bat or doll, and you felt happy just seeing it. Excited, you started to unbox and observe it with sheer joy, feeling happy about the design, colour and fresh smell. After spending some time feeling the new bat or doll, you started playing with it. At night, you slept with a big smile and peace.

How is this childhood experience related to IPOs? We as humans get excited by the newness of a thing. Our brains are wired to respond positively to new stimuli. When we encounter something new, our brains release dopamine, a neurotransmitter that is associated with pleasure and reward. You must have observed that when it comes to taking a decision regarding buying clothes, shoes, a house, a car, etc., we are always excited to own something new and discard the old.

It is the same in the stock market. We are excited when something new comes to the stock market and are curious to know which new company is coming, what their business is, and the price they are offering.

What is an IPO anyway? An IPO is when a closely held company decides to sell their equity (shares) in the stock market for the first time to raise funds to bring new infrastructure, expand their business, repay debts, and many more. They are launched in the primary market. The primary market is a market that provides a channel for the issuance of new securities by issuers (government companies or corporates) to raise capital.

When it comes to evaluating the potential of an IPO, there are several key factors that we wish you to understand before making any decisions. There are two major IPO investment strategies in India.

Sell on Listing: If you have a high-risk appetite, then pursue subscribing for an IPO and selling at the time of listing. This strategy is risky primarily as it is based on market optimism. If the market is in a bull trend at the time of company listing, you may make a buck. If not, then it is a bet to avoid, and you should buy the new company shares after some time.
Long-Term Investment Purpose: There are various steps which we would advise you when planning to invest in an IPO with a long-term perspective. These steps prescribed can be used in any form of business analysis you pursue. Here we go:
1. Understand the Business Model: First and foremost, it’s important to understand the company’s business model, its competitive advantages, and its long-term growth prospects. Is the company in a growing industry? What are the sources of revenues? Is there a clear path to profitability and a sustainable competitive advantage? These are all critical factors to consider when evaluating the potential of an IPO.
2. Look at the financials: You should always look closely at the financials of the company. This includes analysing the company’s revenue, profits, and cash flow, as well as its balance sheet and debt levels. We want to be sure that the company has a solid financial foundation and isn’t taking on excessive debt that could put its long-term viability at risk. Also, look whether the company is using IPO funds to meet only their debt.
  
  For (a) and (b), an investor should carefully review the Draft Red Herring Prospectus (DRHP), also known as the “offer document” or “preliminary registration document.” This document contains all the information related to the issuer, such as its business model, financials, risks, and management team.
3. Check the Valuation: When analysing potential of an IPO before investing, an investor should also pay close attention to the valuation of the company. It is important to determine whether the company is priced fairly relative to its growth prospects and financials. Additionally, it is important to evaluate whether the underwriters and early investors, Anchor Investor are pricing the IPO to ensure a healthy return for themselves, or if they are truly focused on building long-term value for shareholders. Recent IPOs of high-profile companies like One 97 Communications Ltd (Paytm) and Zomato Ltd. have seen significant declines in their share prices, indicating the importance of careful valuation analysis.
  
  Company IPO Date Issue Price Price -7th Apr’23 Return
  
  Zomato 14-Jul-21 72-76 52 -28%
  
  Paytm 08-Nov-21 2080-2150 646 -69%
4. Research company management: The management team of the company is also a crucial factor to consider. An investor should evaluate whether the team is experienced, capable, and aligned with the interests of shareholders. It is important to assess whether the team has a track record of success in the industry or if they are untested.
  
  Do your due diligences on them, including a Google search. One piece of negative press may be a blip or a misunderstanding, but several negative articles may be a red flag. Keep an eye out for the less obvious. For example, some small companies combine chief executive and executive chairman roles, which saves money but leaves a lot of power with one person.
5. Understand the capital structure: Current shareholders and the level of ownership that key management personnel (CEO, chairman and directors) have can be significant in your investment decision. Having well-known investors and directors with substantial ownership in the business should be an encouraging sign as they are more likely to be focused on the long-term success of the company. This isn’t to say that if management own fewer shares that the IPO isn’t a good one but may imply more research is required.
  
  Be sure to look out for things like options and performance shares. Every new share will also impact your holding and some of these may be triggered upon listing. This is important for the true value of your shares and the future of the business. Look for owners who are keen to retain ‘skin in the game’. How much of a stake are they retaining in the company after the IPO, what does the escrow agreement look like and how many options are included in the offer?

Company	IPO Date	Issue Price	Price -7th Apr’23	Return
Zomato	14-Jul-21	72-76	52	-28%
Paytm	08-Nov-21	2080-2150	646	-69%

In summary, when evaluating the potential of an IPO, an investor should focus on the business of the company rather than the amount of return which could be generated from the IPO, especially if they wish to invest for long-term purposes. It is important to carefully consider factors such as the company’s business model, long-term growth prospects, financials, valuation, and management team. By doing so, investors can make informed investment decisions that will create long-term wealth for them. Happy investing!