5 Crucial Factors to Consider While Investing in an IPO

When Invest in an IPO

How do you decide whether to invest in an IPO or to avoid the IPO. Obviously, IPO investment can never be a random affair. It is a methodical process of identifying the IPO options available in front of you and deciding on the IPO stocks to invest through an iterative process. You can use an analysis provided by the broker on the best IPOs to buy and that can be a starting point to invest in an IPO. Let us focus our attention on what is IPO and how to invest in the same and make a dispassionate decision on the same.

Let us start by understanding what is IPO investment and then work out what should be the IPO investment strategy in this case. It can be quantitative alone, but it has to be qualitative and also you must ensure that it fits into your goals. By itself, no IPO is good or bad as long as it is good or bad for your unique needs and that is what matters. The number of shares that you get allotted in the IPO is eventually a function of the IPO allotment process. But, there is a detailed and elaborate homework that you must do preceding your IPO investment decision. The more rigorous the homework, better the chances of an IPO.

Key factors to consider when investing in an IPO?

An IPO entails fresh issue of shares by a company or an offer for sale, but the idea is normally to list the company, improve its floating stock and provide a currency for future valuation. As an investor in IPOs, your focus must be whether that IPO can create value. The first step to value identification is to check on certain things you must avoid. For instance, you must avoid IPOs with dubious business models, where cash flows are far into the future or where the management does not have good credentials and also where the valuation is so steep that it does not leave much on the table for investors. Here are 5 crucial factors to consider before you invest in an IPO.

1. In the absence of too much of information, the one thing that should work in your favour is checking the background of the promoters, their commitment and their vision and outlook for the business. That is because, when you invest in an IPO, you are largely betting on the promoter quality. To put it very crudely, Peter Lynch once said that find out a business that even a high school pass out can run, which means look for simple business models rather than black box models. This may be subjective but there are enough pointers available in the disclosures made in the prospectus. Give a lot of importance to how much importance the promoters give to corporate governance, transparency, disclosure etc. Check the track record of promoters in previous businesses and whether there are major legal cases or regulatory investigations pending against the promoters. These details can be checked in the MCA website and this is normally a red flag. Secondly, in rapidly changing industries that are being constantly disrupted, check how the promoters and the company is prepared? Prefer companies that are targeting to be leaders in the niche, because only leaders will create value.
2. Yes valuations are important because it tells you how much is left on the table for investors. Loss making companies coming out at rich valuations based on fancy projects don’t really work. We have enough instances in the last one year and we don’t need to get into the details. Check the P/E ratio and compare with peer group. Even if the P/E is high but if the growth prospects are healthy, you can still take a chance with that IPO since growth automatically gets higher valuations. The bigger thing you need to focus on is the debt levels. There are enough companies we have seen in the last 10 years which just crumbled under a mountain of debt. The best performers are normally the low-debt or zero debt companies as solvency risk is low.
3. Check where the IPO funds will be utilized. This may sound a small thing, but in an IPO that is perhaps the most important factor in deciding whether the issue is adding value to the shareholders. This may not matter in an OFS, but it is very material in a fresh issue. What are the tests here? Here are some pointers. For instance, use of IPO funds for expanding capacity and scaling up operations in a growing industry is good news. However, be wary of companies that use IPO funds to buy office space, fund working capital or for inorganic growth plans that are still too hazy. What about debt reduction? Now, this is a double edged sword. Debt reduction with IPO money is a good idea when your current cost of funds is too high. However, doing so assumes that cost of equity is lower than debt, which is technically incorrect. Take a measured view on this subject.
4. When you invest in an IPO do channel checks and get second opinion on financials. Here are some examples on what you must do. When the company presents financial projections in the prospectus, take it with a pinch of salt and run some checks. Firstly, is the future growth projection supported by past growth? Look for consistently growing companies because eventually they will be the consistent compounders of wealth. If you are talking about consumer demand projections or new products or massive expansion, then do channel checks to verify if such numbers are reliable. Unless you do these second level checks and channel checks, you would end up just believing the prospectus.
5. Finally, find out if the promoters and the large institutional investors really have skin in the game. What does that mean? Skin in the game means that the core holders should have a long term commitment; and these include the large institutions and the promoters of the company. One proxy to check is the promoter stake post the IPO. Is the promoter trying to dilute as much as possible, because that is not a good signal. You must also be doubly wary if there is too much of promoter equity that is pledged against loans. This is a classic test case for capitulation of the stock at short notice. Check out the names of institutions that have taken pre-IPO placement and keep a tab on anchor investors. Quality institutional participation is always a force multiplier for any initial public offering.

The moral of the story is that the final decision is as much qualitative as it is quantitative. What you can do is to reduce your risk of investing by doing a detailed job of evaluating the pros and cons before actually committing money into the IPO.