Investing in an Initial Public Offering (IPO) can be exciting, especially with several IPOs lining up for the market. However, investing in IPOs requires special consideration due to the lack of a previous trading record for the company. A systematic checklist covering the fundamentals of the business and its valuation can help you make a more informed decision.
Understand the Business and Industry
Before making an investment decision, understand the business, including its field, nature, and mode of operation. Determine the growth prospects of the industry, identify key competitors, and establish what competitive advantages give the company an upper hand over its competitors. Identify competitive strengths such as branding, distribution channels, technology, and cost leadership that can support continued growth even after the company lists.
Consider the ‘Objects of the Issue’ section in the Red Herring Prospectus (RHP) to determine how the IPO proceeds will be spent. Prefer companies that use the proceeds to expand capacity, reduce debt, and support growth rather than those where the issue primarily enables promoter exits through Offer for Sale (OFS).
Evaluate Financial Health and Growth
Since IPO companies do not have a historical trading record in the stock market, you will mainly base your analysis on the financial statements provided in the RHP. Three main financial parameters to pay attention to include revenue growth, profitability, and cash flow.
Revenue Growth and Profitability: Analyse the performance of the company for at least three years with respect to top-line and bottom-line growth. Positive trends, along with improving or stable margins, are preferable.
Cash Flow Quality: Make sure that the operating cash flow supports the reported profitability. Consistent profitability alongside negative operating cash flow may be a red flag.
Debt Structure: Separate short-term and long-term debt. A higher proportion of short-term debt may indicate greater liquidity risk. A net debt-to-total equity ratio of less than 1x generally indicates a more comfortable debt position.
Avoid companies with volatile earnings, poor margins in cyclical industries without a strong competitive moat, or a history of frequent equity issuances.
Scrutinise Valuation
Valuation often makes or breaks an IPO investment decision. Even a quality company can become a poor investment if it is valued too highly.
Compare valuation ratios such as Price-to-Earnings (P/E), Enterprise Value-to-EBITDA (EV/EBITDA), and Price-to-Book (P/B) against listed competitors in the same sector.
Look at the price at which shares were sold during pre-IPO funding rounds. A steep increase from the last private valuation to the IPO price may leave limited room for further gains.
Exercise caution with ‘story’ valuations in overhyped sectors where the fundamentals do not support the price.
Grey Market Premium (GMP) can signal market sentiment but should not form the basis of an IPO investment decision. It is unofficial and can be highly volatile.
Governance and Red Flags in the RHP
The RHP should be of utmost importance to you. Some of the key indicators of governance and risks include the following:
Over-Reliance on Related-Party Transactions: Too many transactions with promoter-affiliated parties could indicate that money is being diverted from the company.
Promoter/Management Compensation: If compensation paid to promoters or managers is extremely high in relation to revenue or profits, it could indicate poor governance practices.
Dependence on a Few Customers/Suppliers: Heavy dependence on a small number of customers or suppliers exposes the business to significant risks.
Liabilities: If legal and operating liabilities amount to more than 10% of the company’s net worth, there could be potential future risks associated with them.
Repeated Capital Increases: Repeated capital increases before going public could indicate continuous funding requirements or promoter exits.
Market Conditions and Listing Environment
The performance of an IPO depends on the market sentiment prevailing at the time. During bullish phases, even average IPOs can trade above the issue price, while during volatile or corrective phases, high-quality IPOs may trade below the issue price. A fair percentage of IPOs have listed below their issue price in recent years.
Monitor subscription levels and the interest shown by institutional investors during the bidding period, but do not invest in an IPO simply because it is oversubscribed.
Practical Steps Before Applying
-Study the RHP carefully, particularly the sections covering risk factors, financials, and the objects of the issue.
-Make sure that the IPO suits your risk profile and portfolio allocation to avoid overexposure to a single sector.
-Be disciplined: focus on business fundamentals and medium- to long-term potential rather than short-term listing gains.
-Seek advice from a financial advisor if you are unsure about valuation or sector-specific risks.
By following these steps, you can approach the IPO market with greater confidence and make more informed investment decisions.