Initial Public Offering: 7 things to understand before investing in an IPO

Checking the past performance of the company whose IPO you’ve shortlisted can help in better understanding its business model.

A booming stock market presents an excellent opportunity to investors who understand the avenue well and can effectively handle the associated risks. However, rushing to invest in the stock market purely based on hearsay can lead to heavy losses.

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That being said, you can invest in the shares of a company through the primary market, i.e., via Initial Public Offerings (IPOs), or through the secondary market, i.e., after the IPO listing. Due to the current bullish trend, several unlisted companies are lining up with their IPOs to unlock their intrinsic values and raise capital. Some of the companies coming up with an IPO are well known and have huge brand value in the market; however, you may not know much about some other companies which too are planning to come up with their IPOs during the same time.

In the last one year, returns from IPOs have indeed been phenomenal. One of the reasons for good returns is the continuous bullish trend in the stock market. But the real test for the stocks happens when the market turns bearish. As the stock market is at its peak, what are the things you should keep in mind if you want to invest through IPOs? Let’s discuss a few pointers.

Understand the business of the company

Before you invest in an IPO, you should be aware of the kind of business the company is involved in. You should ideally prefer such companies which are into a business that has a high growth potential. A high-growth business will allow the company to make consistent profits and increase its revenue. You might want to avoid investing in IPOs of such companies whose business activities are unclear to you.

Check its past records, including promoter and management background

Checking the past performance of the company whose IPO you’ve shortlisted can help in better understanding its business model. The company’s promoters should be experienced and efficient in driving the company towards new heights. You may want to avoid companies that have an unstable promoter group and management. Frequent changes in a company’s management can result in wrong decisions and a lack of trust among its investors. So, it’s better to avoid investing in the IPO of such companies.

Analyse key financial parameters to assess the growth potential

By analysing crucial financial data of the company, you can find out its financial health and assess its growth capacity. For example, knowing the company’s debt-equity ratio can help you assess the company’s degree of leverage. A high debt-equity ratio often indicates a higher risk in a company. Similarly, you may analyse the company’s earnings per share (EPS), cash flow, return on capital employed, and other key financial ratios before deciding to invest in it. Avoid investing in an IPO if its financials are not up to the mark and valuations are weak.

Compare with the peer group

Comparing a company with its peer group is another good way to analyse an IPO. Suppose the company which is coming up with an IPO has a good market share and attractive financials compared to its peer group, but the IPO’s offer price is lower. In that case, it can offer a big opportunity to make money. On the other hand, if the company is coming up with an IPO pricing that looks expensive compared to its peer group, you may prefer to avoid investing in it.

Learn about the risk factors

Sometimes the company which is coming up with an IPO carries high risks, but you may not know it by looking just at its financials or operations. To know about such risks, you should carefully read its Draft Red Herring Prospectus (DRHP). Companies mention all risk factors that may impact their businesses in the short and long term in the DRHP. It may include litigation, contingent liabilities, and the possible threats which may impact its normal business operations.

Get clarity on your investment purpose

Investing in an IPO for listing gains may not be a bad idea, but it should not be the sole purpose to invest in it. You should select such a company with good fundamentals that can allow good returns in the future even if it fails to provide listing gains.

A few other key points to keep in mind

Investment in IPOs should be in complete sync with your financial goals and risk appetite. Avoid investing with borrowed funds in anticipation of quick gains. You should also try to invest in an IPO on the second or third day after opening. This will help you in assessing the public response. If the issue is oversubscribed by several times, chances of listing gain increase. In an IPO which is highly oversubscribed, you may invest in fewer lots because the chances of getting multiple lots become low in such a situation.

(The writer is CEO, BankBazaar.com)