Initial Public Offerings (IPO)
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Analysing IPO – Investment Research
Till now, we have covered the topics related to applying for an IPO, but it is important to analyze before applying for the IPO. But how? The answer is going through the Red Herring Prospectus (RHP). So let us begin:
What should investors look for in the Red Herring Prospectus?
Red Herring Prospectus or RHP is a preliminary document submitted to the SEBI containing all relevant information and disclosures about the company wishing to go public through sale/issue of equity shares.
For the screening & evaluation of an IPO, Investors should carefully read the prospectus and go through all the details disclosed by the Company. However, the problem is that RHP is an unusually long document and few people take the pain of going through it exhaustively. Nonetheless, investors must pay close attention to a few headers under the RHP before committing their capital:
Issue Name: It is the name of the company going for IPO
Issue type: There are two major types of issue i.e, Fixed Price & Book Building
Issue Size: This is the total number of shares to be issued to the public
Face value: The face value is the nominal value of the stock and issue price is decided as premium over the face value of a share.
Price Band: In case of book building maximum and minimum ( Cap & Floor) price within which the bid process takes place.
Category: There are four main categories of investors namely, Retail Investors (RIIs), High Net worth individuals (HNIs)/ Non institutional investors (NIIs), Qualified institutional bidders and Anchor investors.
Start date/End date: Opening and closing date of the issue generally 3-7 days in case of book building.
Minimum/Maximum Investment value: Application value more than ₹ 200,000 are considered as HNIs and anything below ₹ 200,000 is considered Retail institutional investors (RIIs).
Minimum order quantity: This is the minimum number of shares investors can apply while bidding in an IPO. If investors want to bid for more shares, they can apply in multiple lots.
Lot size: It is the quantity multiple for issue. For example if the lot size 50 and the investors want to apply for 300 shares, he can apply for 6 lots (50x6=300 shares)
Tick size: It is the price multiple within the specified price band. For example, if the price band is ₹ 200-250, and tick size is ₹ 10, then the acceptable price value is ₹(200,210,220,230,240,250).
Lead managers/ Book running lead managers (BRLM): They are involved with the company in the complete process of IPO. They have to get the pricing of the IPO right, along with compliance and ensure success of the issue. Few renowned BRLMs are Goldman Sachs, Morgan Stanley, Merrill Lynch, etc.
Listing exchange: Listing of shares can be done on Bombay stock exchange (BSE), National stock exchange (NSE) or both.
Credit rating : Higher credit ratings indicate the company's strong fundamentals.
Registrar to the issue: They are mainly involved in processing IPO applications, allocate shares to applicants based on SEBI guidelines, process refunds through ECS or cheque and transfer allocated shares to investor’s Demat account.
Pre-IPO placements are an excellent barometer of investor demand for the issue. Often, these are used as marketing tools by the company to publicize their IPOs by citing marquee investor interest. For instance, ahead of its public issue, Avenue Supermarts or D-Mart raised ₹561 crore by issuing 1.87 crore equity shares at the higher end of the price band to 35 anchor investors, including General Atlantic Singapore, Fidelity, Franklin Templeton, Goldman Sachs, JP Morgan, HSBC, Motilal Oswal, and UTI, among others in December 2019. Rossari Biotech, which launched its IPO from 13th July to 15th July 2020, raised ₹100 crore in pre-IPO placement in March 2020 by placing equity shares with Malabar India Fund, White Oak, Kotak Infina, Axis AMC, Mirae Asset, Sundaram Mutual Fund, IIFL and ICICI Lombard General Insurance.
The objective of the Issue
It is of vital importance for an investor to know the purpose of an IPO i.e., how does the management plan to utilize the IPO proceeds. Investors should check the RHP detailing whether the funds will be utilized for funding future expansion, debt repayment, or to meet the company’s working capital requirement. Investors should be cautious if the promoters or private equity firms want to exit the company by offloading their shares.
Company Background & Business Profile
Company background and business profile shall provide investors with the framework of the industry the company operates in. Investors must cross-check management claims from other sources in their personal capacity. Also, the following points must be made note of:
- What are the future prospects or the demand of the product or service offered by the company? What are the plans for expansion? Is the company going to enter into new markets? How does the company intend to raise funds in the future?
- What type of industry does the company operate in? Is the majority organized or unorganized? Is it cyclical in nature? What is the company’s market share and competitive advantage for the business's products or services? Is there an instance of client or geographic concentration?
- Are the operating margins of the company stable? What is the company’s plan of action in case of a sustained rise in the prices of raw materials? Is it able to pass on the higher cost to its customers in the form of price hikes or does it take a hit on its margins?
- Compare the business metrics with listed peers locally as well as globally. Analyze the reason behind considerable deviations from the average.
Promoters & Management
Management pedigree is the single-most paramount factor affecting investment decisions. The promoter’s experience, the management team, their expertise, backgrounds are few factors to be considered before investing in an IPO.
- What kind of goals has the management set out for the company?
- Do they have a successful history in business ventures?
- Do they have business expertise and qualifications to run the company?
- Does management itself own any shares in the business?
- Are the promoters cashing out in the IPO? If yes, analyze the reason.
- Do the people involved have previous experience running a publicly-traded company?
The IPO should be avoided in case the investor notices significant red flags.
Concerns / Risk Factors
The section on risk factors in the initial page gives information if there are legal cases pending against the company. It is advisable to wait for clarity on this front if the dispute has a consequential bearing on the fortune of the company before investing your money. A lot of pending cases might be an indication of poor corporate governance practices in the organization.
The Balance Sheet must be carefully analyzed to gauge the financial position of the company. A high gearing ratio can be a sign of stress in the company. Investors must analyze the historical financials of the company before forming investment decisions. The key financial parameters to analyze before investing in an IPO are:
- The trend in Revenue and Profit – Positive/Upward sloping
- Operating and Net Profit Margins – Higher the better
- Earnings Per Share – Higher the better
- Return on Net worth and Capital Employed – Higher the better
- Debt to Equity Ratio – Lower the better
The companies with high volatility in financial numbers should be avoided for investment.
Investors also need to analyze if the issue is worth considering at the offer price. The Price-Earnings (P/E) multiple is one of the tools that can be used to gauge the attractiveness of the issue.
The P/E multiple is the ratio of the share price to Earnings Per Share. The P/E Multiple of the company should be compared with the industry average and the other listed companies in that sector. A Lower P/E indicates the company is undervalued. Investors should not blindly subscribe to an issue just because of a lower P/E multiple & must examine the reason behind such undervaluation.
Other metrics such as Price to Book Value (P/B Ratio), Post-Issue Market Capitalization to Sales, Price to Earnings Growth (PEG Ratio), EV/EBITDA, Equity (Net Worth) Growth rate, Operating Free Cash Flow Growth Rate, amongst others must be used in conjunction with P/E ratio to evaluate the lucrativeness of the investment.
Do not worry! We will discuss- What is Grey Market? and also understand the other factors considered for investing in an IPO. Let us learn that in our subsequent units