Evaluating an IPO

How to evaluate upcoming IPOs

With a number of IPOs in the offing, investors should know how to find out which ones are worth investing in.

A bull run in the secondary market is usually accompanied with a lot of action in the primary market.In the current bull run, however, very few initial public offers (IPOs) have come to the market. Sebi's guidelines for bringing out IPOs have become stringent. In the wake of a sluggish economic recovery, corporate earnings have not turned robust enough to be able to attract investors. And private equity investors are finding it difficult to get a good price at which they can exit.

Things are, however, beginning to look up. The IPO pipeline is strong. Investors will be willing to look at quality issues if they are available at a reasonable price."

Why are IPOs riskier?

A lot of information is available in the public domain on companies that have been trading on the exchanges for some time. A company's annual reports, media articles and reports issued by brokerage houses are available. Companies also file disclosures with the stock exchanges. In case of an IPO, the investor has to depend almost en tirely on the red herring prospectus (RHP).

Lack of a track record is another issue. You do not know the level of transparency and corporate governance these companies will observe.

One does not know how credible the management is in terms of being able to achieve the guidance it gives, and whether the information it shares can be trusted. For listed companies, analysts have a fair idea based on interactions with the management over the years.

Evaluating an IPO

The process of evaluating an IPO is not very different from that employed for a listed company. Look at the competitive advantages of the business, the quality of its management, and the relative pricing of the stock.

Investors should read the important sections of the prospectus, available on Sebi's website. Sections like "Summary" and "About us" should be read to learn about the company's strengths and ability to fight competition. The section on industry will tell you about the industry structure, growth prospects and competitive intensity.

Look up the financials to learn about past growth rates (revenue and profits), margin profile and the return ratios. Comparing the newcomer with listed peers will give a fair idea of its financial robustness.

The prospectus will also tell you about the management: its background, track record and vision. If you know people in the promoter's hometown, make enquiries. People in the same city tend to know about the reputation of fellow citizens. If the promoter is unscrupulous, he won't be willing to share gains honestly with shareholders.

Compare the new player's valuation with that of its listed peers.Promoters and investment bankers sometimes price the offer expensively. If that is the case, steer clear. You can always buy the stock later when it corrects.

The section on risk factors will tell you if there are legal cases pending against the company. If there are too many cases pending, stay away.

For those who can't or won't do rigorous research, Haldea suggests they look at the level of institutional bidding. If the institutional response is strong, it means that both the company and the price have been validated by institutional investors. Check if private equity investors are exiting the company at the time of the IPO. It indicates that they don't foresee an exciting future for the company, in which case don't bet on it either.

Mistakes to avoid

An IPO is accompanied by a lot of marketing hype. Don't allow it to mar your judgement. The the market is willing to pay a very high valuation for certain sectors and companies in bullish conditions. Avoid getting swayed by the fads.

Do not invest for listing gains

Listing gains can't be taken for granted in uncertain market conditions. Shah adds that sometimes IPOs get over-subscribed, but by the time listing happens, market sentiment changes and there are no listing gains. In his opinion, investors should have a medium to long-term horizon to earn decent returns.

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