How To Invest In An IPO? We Cut Through The Clutter And Tell You The Correct Way To Buy One

The one abbreviation that has dominated the year 2021, is IPO. Big names like Paytm, Zomato, Kalyan jewellers, Glenmark Lifesciences, Aditya Birla AMC and Policybazaar, to name a few, have already wrapped up their IPOs. But the story is not over yet. Thanks to the positive market sentiment this year, the IPO frenzy is reaching newer heights, and is clearly visible through the long list of businesses rolling out IPOs.

With a strong pipeline of more companies expected to flood the equity market this year and early next year, it¡¯s natural for many of us to feel FOMO (Fear of missing out). But before you jump into believing any biased opinions about a business or their public offer, let¡¯s walk you through the entire gamut of IPOs and what to keep in mind before investing in it.

shutterstock

What is IPO?

Simply put, an IPO is both a process and avenue through which shares of a private corporation are offered to the public through new stock issuance. As IPO¡¯s primary objective is to raise money by borrowing through the issue of shares to the public via the first public invitation in the stock market, it is thus termed as ¡®Initial Public Offer¡¯. Through an IPO, companies are able to raise equity capital by issuing shares to the general public, thus enabling the public investors to participate in the offering and giving the investor some ownership in the company in accordance with the value of shares allotted and owned. An IPO also marks the transition phase of a privately held company into a public company.

Now that you understand the basic meaning of IPO, you must be even more curious to know how to choose amongst various IPOs and get your skin into the game, right? Especially in the current market scenario wherein scores of IPOs are lined up, investors are certainly spoilt for choice. So, knowing which IPO to invest in can be a tricky task. That's exactly what we aim to assist you on by explaining some of the crucial evaluation criterion upon which you should identify the right IPO to invest your hard earned money in:

shutterstock

First be clear of your investment horizon, objective and risk profile

Before taking the leap of faith and jumping into the ocean of IPOs, you should be clear about three things

1. How long do you want to stay invested?
2. What do you aim to achieve?
3. And how much risk you're willing to take?

If you have the answers to these three questions you've made your life simpler. Being clear of your risk profile (risk averse, moderate or high risk taker) and the reason behind investing in IPOs would help make your hard earned money work for you. Also, be clear whether you wish to invest in the IPO just for a quick short term profit on listing day, or hold the shares for a long term. Remember that short term strategy would depend more on current market sentiment, whereas long term one would depend on the core fundamentals of the business.

Once you are clear about these three parameters, it becomes easier to eliminate those companies that do not meet your objectives and shorten the otherwise long list. Here are the next steps

Do deep researching about the company

Would you ever hand over your wallet full of cash and cards to a stranger? No, right? Then how can you invest your money into a company without enquiring and researching about it? When it comes to investing into a company¡¯s IPO, never rely on hearsay or biased opinions even of your friends and family.

The best and probably the only solid way to zero in on any IPO is by first conducting deep research about the company. To help with this, you can download the company prospectus from its official website or even from SEBI¡¯s website, and give it a thorough reading. The prospectus acts as a good starting point for your research. If you aren't able to understand parts of it or the financial jargon, a quick google search is all it takes to clear things up. The prospectus mainly contains information regarding the company¡¯s financial performance, reason behind issuing an IPO, details about the promoters, dividend policy, regulatory and statutory disclosures, offer information, details about the management etc. We will also explain to you how to read the prospectus in the later part of this article.

Also to further complement your research, go through the media reports about the company and keep a tab on any recent developments regarding the same. To gauge how strong the company is fundamentally, check for red flags like cases of defaults in corporate governance, any legal disputes the company might have landed in, ongoing compliance issues, hasty managerial exits, etc . Only when you are fully satisfied on all fronts, should you proceed further with the IPO investment. Even though all this might seem time-consuming, never bypass this step. Your own research can help you discover some weak spots that can anchor your decision. As the saying goes - Devil lies in the details!

Know where your money goes

shutterstock

Once you have thoroughly researched the company whose IPO you want to invest in, the next step is to know where the IPO proceeds will go. Knowing what the money raised from IPO would be utilised towards, can give a glimpse regarding the potential of returns and growth. For instance, if the company intends to only repay the debt through the money raised from the IPO, then it might not sound like a lucrative option. But if the company says it plans to partly repay the debt and use the rest for purposes like expanding operations, discovering new markets, acquisitions or increasing production capacity, then it sounds like a good option, as it shows that the invested money will actually flow into the business and contribute towards potential growth.

Look at the valuation

Valuation is nothing but the worth of the company whose IPO you're interested in. There are not one but multiple techniques used by analysts and economists for arriving at a company¡¯s valuation. Numerous aspects like the business' management, composition of its capital structure, prospects of future earnings, market value of its assets, number of stocks being sold in IPO, potential growth rate, financial performance, current market price of companies listed in the same sector etc are amongst the factors and metrics taken into consideration during valuation. One should ideally see how the valuation of a company fares vis-a-vis existing companies and competitors in the same industry when contemplating the idea of investing in its IPO.

Also, while there are techniques such as Return on equity (ROE), Price to earnings (P/E) ratio, price to book ratio etc that can be used to judge the valuation better. It's always a good idea to learn about these ratios. To add to your own research, look at what the financial analysts and economic experts are saying about that IPO, but take your own decision.

Check the supporting cast

Another crucial parameter to understand and judge an IPO is through its support cast, such as the promoters, underwriters, investment banks and major stockbrokers backing the IPO. This supporting cast plays a key role in sailing the IPO through. Look out for signs such as promoter¡¯s stake pre and post the IPO (significant reduction can be a red flag), exit of anchor investors (exiting the company in totality can be red flag), track record of the investment bankers, etc. All these depict the potential quality of the company and its IPO. However, make sure to take these as positive signs, if present, but not solely rely on them or assume their presence as a signal of guaranteed returns. Above all, learn to always stick to your research and analysis of the company¡¯s fundamentals as well as potential growth prospects before taking the final call.

Last but not the least, remember that scepticism is a positive attribute when it comes to investing in IPOs. Whenever you think of getting your skin into them, it¡¯s always better to tread with caution. And besides the parameters discussed above till now, a ton of key information surrounding the company¡¯s IPO is mentioned clearly in its DRHP. Given that the prospectus is amongst the most crucial pillars in the process of IPO, let¡¯s understand the DRHP a bit more so that you can read and understand that in totality and accordingly take an informed decision.

What is a Draft Red Herring Prospectus?

Sharon Mccutcheon

Every IPO is accompanied by a prospectus. While it may seem like a comprehensive and bulky document, reading and understanding is not an option but a necessity for potential IPO investors, as the information mentioned in the prospectus can determine whether to invest in the IPO or not. First, the company aiming for IPO files a DRHP (Draft Red Herring Prospectus), which is the draft prospectus of the IPO. SEBI goes through the DRHP and recommends changes, if any and/or approves it. Post SEBI¡¯s approval, the DRHP becomes an RHP, i.e. Red Herring Prospectus. As the prospectus is probably the most important document in this entire process of IPO, both for issuer and the investors, let¡¯s quickly have a look at the various sections of the prospectus:

1. Industry and Business Overview

This highly detailed section offers a macroeconomic view of the Indian economy, including the GDP growth and consumption patterns in the economy. It also offers a bird¡¯s eye view of the industry in which the company belongs, and mentions an industry-specific view of the favourable demographics, growth drivers, opportunities, challenges, and macro & micro-level analysis of the industry as well as its sub-segments.

Besides the industry dynamics, this section of prospectus also offers a detailed view of the issuing company, its business operations, and typically also lists the range of products and services offered by it, its size of operations, and the principles that drive the core business.

2. Strengths

The prospectus also lists the strengths of the company, both internal and external. As the strengths are what give the company an edge over competitors, going through this section can help you understand the potential of growth it holds in future.

3. Strategies

In this section, the strategies adopted by the company to establish and grow its business are mentioned, including product-level strategies, geographic strategies, market-level strategies, etc. Going through this section can help you to understand the strategies and approach taken by the issuing company to generate profits.

4. Operations

This section offers insights into the processes and systems followed by the issuing company to offer its products and/or services to the consumers. From the manufacturing processes, pricing policies, internal processes, quality monitoring systems to marketing plans, this section offers you the opportunity to better understand the way the issuing company goes about its business.

5. Regulations and Policies

This section offers summarised details of the laws and regulations applicable to the issuing company, such as the name of the Acts under which the regulations are mandated, environment regulations, tax laws, employment regulations etc. Going through this allows you to better understand the extent of regulation present in the said industry. Generally, under-regulated industries are much more prone to attract the wrong companies due to the presence of lots of loopholes and lack of adequate laws and regulations, hence making it a possibility that investing in their IPOs can turn out to be counterproductive.

6. History

This section helps you understand the growth trajectory of the company through its history, including its major events and landmarks.

7. Management

This section lists the Board of Directors of the company along with the details of each director.It also includes a brief biography of each Director, the payment details of all Directors, and committees of the Board. This gives you a brief overview of the key people in the company¡¯s board.

8. Promoters and Promoter Group

As promoters are amongst the key supporting staff that anchor an IPO¡¯s success, make sure to go through this section to find complete details about the promoters and/or promoter group of the company.

9. Risk Factors

Given that investing in equity shares naturally carries risk, this section lists all possible risks faced by investors of the company, knowing which is crucial for those planning to invest in that company¡¯s IPO, as they would then evaluate the potential risks and assess whether their risk appetite allows them to go ahead or not.

10. Details of the Offer and Offer Information

Another vital section is this, which offers all details about the IPO including the number of shares offered via fresh issue and offer for sale,retail portion, the terms of the IPO like ranking of equity shares, mode of payment of dividend, face value, offer price, price band, rights of shareholders, offer structure and procedure, important dates, technical rejection grounds, general terms and conditions etc.
By going through this important section, you can understand the finer details about the IPO. Hence, never miss out on this section when researching about the potential investment in a company¡¯s IPO.

11. Capital Structure

This section mentions details about the Equity Share Capital of the issuing company, as on the date of the Red Herring Prospectus (RHP). This includes the authorised share capital and issued, subscribed, and paid-up capital before the IPO. Information regarding the history of the equity share capital held by the promoters of the company is also mentioned here.

12. Objectives of the Offer

This section lays out the details regarding how the company plans to utilise the funds collected via the IPO. As a potential investor, this information can be vital in order to assess if the company is focusing on growth through funds raised, or aims to steady the ship, or achieve any other goal.

13. Financial Information

As its name suggests, this crucial section includes an independent auditor¡¯s examination report on restated consolidated financial information, the restated consolidated statements of assets and liabilities, profit and loss, cash-flows, changes in equity, current as well as non current loans and financial assets, other tangible assets, inventories, share capital, borrowings etc.
Each of these statements offers an insight into a particular financial aspect of the issuing company. Although the financial jargon and information mentioned in these statements cannot be understood by everyone, professional assistance can be sought in order to make sense of these financial statements, as it can certainly impact your decision making and understanding surrounding the IPO.
Besides these sections, the prospectus also includes other sections and information like dividend policy, legal information, basis for the offer price etc. Its always advisable to thoroughly go through the prospectus so that you are able to take an informed decision regarding whether to invest your hard earned money into that company¡¯s IPO or not.

Where Can You Find the RHP?

You can easily find the issuing company¡¯s RHP at the official website of SEBI and the websites of Stock Exchanges and select Merchant Bankers. Further, the issuing company has to make a public announcement through at least one newspaper after submitting the RHP to SEBI.

So now you know how to read the DRHP and can take your own informed decisions about investing in IPOs. If you think Mutual Funds are safer or you'd let a fund manager manage your money, we've got you covered. If you don't know where to start, we have a simple guide to get started with investing too.

For more of such interesting financial content, click here.

Click here to download CRED