Home / Money / Personal Finance /  What to look out for when you put your money in IPOs

Amid the initial public offering (IPO) frenzy, investors flush with money are making a beeline for every such offering. Investors need to ignore the euphoria and evaluate multiple inherent and external factors before subscribing to a new offer.

Since covid-19 hit Indian shores in March 2020, the equity markets have oscillated wildly. While the initial panic and fear sent markets plummeting, equity markets have thrived over the past 15 months the and an all new breed of investors has emerged.

This investor is not risk-averse, is flush with liquidity and is willing to even trade in stocks to make profits. Corporates perceptive of the heightened willingness to invest in equities have lined up to get companies listed through IPOs.

“In a market scenario like the present one, investors are driven by sentiment and emotions rather than the fundamentals and valuations of a company. The objective shifts from long-term investing in a sound business to making quick money by selling as soon as the company gets listed and there is a listing gain," said Tanushree Banerjee, co-head of research, Equitymaster Agora Research. However, what is required from investors is a deep understanding of their own financial objectives, investment horizon and risk appetite and an analysis of various external factors such as core business and business model.

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Every company filing for an IPO must submit a DRHP (draft red herring prospectus) to the Securities and Exchange Board of India (Sebi). The DRHP is extensive, and usually spans over 500 pages, which can be overwhelming for investors. “Besides investors not knowing what to analyze in a DRHP, (these documents) may not show a complete picture (to the investor) as it is a glorified financial overview prepared by the lead manager of an IPO," said Banerjee.

Instead, investors must try and understand the core business of a company, how it earns revenue and makes profits. “While you may be aware of a company such as Zomato and use the services regularly, it is advisable to understand how the company functions and its business model. Once you own a stock, you become a part owner of the company and thus it is important to understand if the business model and revenue generation appeals to you as a stakeholder," said Banerjee.

Understanding the business and how it generates revenue is even more pertinent when it comes to new-age businesses going for IPOs. For such companies, which face the risk of obsolescence, a solid business model and sound financials matter over the first-mover advantage.

Objective of the IPO: How a company will utilize the proceeds from an IPO is the most accessible information and easiest for an investor to evaluate. If a company is getting listed to scale its business and infuse capital for capacity building, it is more reassuring to an investor compared with a company going public only to give an exit to existing stakeholders.

Financials: While reading a balance sheet and profit and loss statement may not be easy for all, a retail investor can, with the help of the DRHP and balance sheet, look out for the following financial aspects of a company: Consistent increase in revenue and profit over the past five to 10 years (for loss-making companies, operating margins can be observed); positive and increasing free cash flows and cash flows from operating activities; low debt-to-equity ratio and reducing debt; unexplained jumps in revenue and profit in the year the IPO is being floated; huge debts and liabilities; a large number of subsidiaries, and the presence of numerous inter-company transactions.

Investors must also be wary of the following indicators: Numerous pending litigations and contingent liabilities; high remuneration for promoters and management (as a percentage of sales); and prior frauds, controversies or delisting of a company.

While analyzing these various factors discussed, investors must also compare the financials of the company with those of its listed peers and competitors. The price-to-earnings ratio, return on capital employed, and earnings per share of a company and its competitors must be compared to have a complete picture of a company’s standing.

Promoters and management: One of the ways an investor can review the quality of promoters and the management is to identify the institutional shareholders of the company. A higher shareholding by reputed institutional investors and government/government bodies in a company is more reassuring of the quality of the team. This is a proxy measure, as such bigger institutions deploy considerable resources in reviewing the business operations and due diligence before investing.

The quality of the management is a major determinant of how a company will perform. While reputed or well-established management personnel bring credibility to a company, it is difficult for investors to ascertain the quality of the management beyond a point. In such cases, the prior experience, credentials and educational background may be studied. “Important factors such as how the minority shareholders are treated, dividend declaration, regulatory compliance, etc. can be determined accurately once a company is listed and has a track record. Thus an investor can focus on the credentials of the management, promoter and auditor to judge the credibility of the company", says Banerjee.

Before investing in an IPO, an investor must ascertain why he/she is subscribing for the issue. It is important to remember that there is a difference between long-term value investing and short-term investing. In long-term investing the investor believes in a business and wishes to become part owner of it whereas in short-term investing the focus is on quick returns.

When it comes to long-term investing, an investor must focus on the fundamentals of the business as mentioned above rather than eye listing gains that are simply driven by market euphoria.

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