Determine which IPO is worth Investing

Determine which IPO is worth Investing

When you invest in any IPO, the issue is not just about whether the IPO is good. It is also about whether the IPO fits into your financial needs. IPO investments have to be customized to your needs and fit into your overall financial plan. Having understood the initial public offering meaning, it is time to understand how to put your IPO application and how to buy IPO online. That is just one part of the story.

There are more practical questions that you need to address. For instance, which demat  account is best for IPO, is a decision that you need to take. You must also screen and short list what are the best IPO stocks to buy now. Thanks to online demat, the preparatory process is quite simple for an IPO. The more complex part is zeroing in on the right IPO that suits your profile. Here is how to go about deciding if the IPO is worth investing in.

Remember that not every IPO is a ticket to big profits. That is because, not all IPOs experience a stellar listing on the stock exchanges. In the last one year itself, there have been scores of digital IPOs that fell woefully short of expectations on the post listing performance. That is where your role comes in. You must first ensure that it is worth investing in that particular IPO. While there is no foolproof guid, here is how you can go about the job. Here are a few questions that you must ask about the IPO.

Do I really understand this business that the company is into?

This rule is called the comfort zone rule. For instance, if you are working in the steel industry, then look to invest in steel companies or other metal companies to start with. Don’t jump into digital IPOs, where you have limited understanding at this point of time. This is the first and the most important factors that you keep in mind when deciding whether an IPO is worth investing in or not. A simpler way to put it is to check if you understand its business. That is a slightly fluid question, which is why you can start with the industry that you are working in or professionally involved and where you grasp dynamics. That way you would eminently be in a position to gauge the company’s financial performance and future prospects. When you understand the business, you are able to understand financials, performance, efficiency and also the potential industry level disruptions.

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Table of Content

  1. Do I really understand this business that the company is into?
  2. Does the company have a leadership position in the industry?
  3. IPO is as good or bad as the last few quarters
  4. How good are the promoters and the management?
  5. How are the IPO funds being utilized by the company?

Does the company have a leadership position in the industry?

Not every company that comes out with an IPO is a large company. However, they can still have a niche and have leadership in that niche. There are many small companies that are leaders in areas like engineering, artificial intelligence, defence technologies drone technologies etc. That is why you look at the company’s position in the industry and where it stands versus its competitors. Ideally, prefer investing in companies that are in the top-3 in any niche segment of the industry. Otherwise, they have little bargaining power or pricing power in the industry segment. Avoid companies that are operating in an already overcrowded industry or where they have limited market share. Here the traction that they can create in terms of shareholder value would be very limited.

IPO is as good or bad as the last few quarters

In the business of IPOs, you are what you delivery and the company is as good as the numbers that it delivers. Look at the financials closely. The financials give you a host of key information about the company over the last few years so you get sales, profits, margins, efficiency ratios etc over the last 3 years. Watch out for red flags in the numbers, especially factors like negative working capital, too much leverage low coverage ratios etc. These can be pain points in the future and can have a deep imprint on valuations. Always look for steady performers that have been growing on a consistent basis. Ideally prefer to invest in IPOs of companies that have revenues and profits rising steadily over the past few years. Be wary of companies where the profits are erratic or where there have been frequent losses and cycles in sales.

How good are the promoters and the management?

Like Warren Buffett once said, look for a good manager who can handle the business with ease. Avoid managers who unnecessarily take on too much risk just in the quest for higher returns. At the end of the day you need to earn attractive risk adjusted returns on capital. That is why the promoters and the senior management are the heart and soul of the company. They set the tone for corporate policy, management style and corporate governance. Prefer companies that have been transparent about their journeys. Also digress a bit and even look at the background of the promoters and the management. Especially, if you find red flags like frauds, regulatory overstepping, prolonged investigations etc, it does not speak too well about the quality of the management. The onus of the top management quality is largely on the board, so the quality of the board will also make a big difference to the performance of the IPO. Here are some things to be cautious about. Be wary if there are too many top level management changes or too many sudden exits, or short tenure of managers. These are all not healthy signs. Also look at the quality of the independent directors as it can make a big difference to the quality of corporate governance. 

How are the IPO funds being utilized by the company?

If the IPO is a fresh issue or has a major fresh issue component, an important aspect is how these funds are being utilized. There are no clear rules, but you can always make good with some benchmarks. 

• What is the most preferable scenario? It is if the issuer plans to use the IPO funds for expansion of its business, purchase of equipment or acquiring other businesses. That is a sign of growth. Now growth can be organic or inorganic. However, be wary of IPOs which raise money for inorganic growth but have not divulged any details of the kind of companies they plan to acquire. That is not transparent enough.

• Be wary of companies raising IPO funds for working capital expenses or for routine general expenses. That is not what capital is to be raised for. Any IPO funds should lead to creation of assets; either physical or intellectual. That is the guiding principle.

• Finally, be neutral if the IPO is to repay debt. It is not a bad idea, but it assumes that cost of equity is lower than the cost of debt, and that can be a dangerous argument. Above all, be cautious if the issuer has not disclosed how it plans to use the funds. It is better to give such IPOs a miss.

To be fair, the above list is just illustrative and not conclusive. There are several other factors that you can and should consider while evaluating an IPO such as the future growth potential, entry barriers, moats created, risks of disruption in the industry, peer group comparison, valuations of the sector etc. The more factors considered, the merrier.