Investing in an IPO can be one of the best ways to build wealth. You get the chance to grow with the company. There have been instances of both a company performing exceptionally and dreadfully. This is why you should conduct thorough research and consider some factors before investing in an IPO. A proper analysis of IPO can help in making a wise investment decision.
Let’s find out more on this.
What Are the Components of an IPO?
An IPO basically has two components – Fresh Issue and an Offer for Sale.
How are these two different from each other?
It is important to know the difference between these two as they have a material impact when it comes to analysing an IPO. A Fresh Issue is when a company issues new shares and offers them to the general public for sale through an IPO.
On the other hand, an Offer for Sale is when existing promoters or investors strip their stakes.
Additionally, some companies also have anchor investors. These are the investors to whom the company sells a part of their shares before going public. This is done to build the confidence of retail investors. These shares have a lock-in period of 30 days.
What Are the Factors to Consider before Investing in an IPO?
Now that you know about the two major components that make up an initial public offering, let’s understand the factors you need to consider before investing in an IPO:
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Go through the prospectus
It is mandatory for every company going public through an IPO to draft a Red Herring Prospectus. No company can issue shares or stocks if it doesn’t draft a prospectus. A potential investor can comb through this prospectus to find details regarding the issuing firm, such as market vision, founders, promoters, growth prospects, structuring, etc.
However, these drafts are unlikely to include any negative comments about the company. Hence, it is wise to conduct in-depth research on your own.
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Find out the objective and purpose of the IPO
As a potential investor, you should assess a company’s objective. This means getting an idea about what the company plans to do with the proceedings in future. Most companies want to expand their business. It is advisable not to invest in companies that plan to use the proceedings to pay off existing debts.
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Consider checking out the company’s financials
A company’s financials are the most reliable data to determine whether you should proceed with the IPO or not. A well-established company must perform consistently on an upward trend in generating revenue. It should also have considerable cash reserves and show profitable growth with a low debt burden.
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Scale the public demand for the IPO
Going with the herd mentality is not considered wise when it comes to investing in the stock market or mutual funds. But when it comes to IPO, one of the best ways to determine whether you should invest in an IPO or not is to gauge its public demand.
If the public demand is high, the IPO will most likely be oversubscribed. On the contrary, an undersubscribed IPO shows poor public demand and might not be an ideal investment choice.
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Consider the growth prospect of the company
A business grows through constant competition and innovations. When a company requires capital, it will most likely use the fund to broaden its business objectives or to expand it further. A company which aims to utilise the capital to compete with its rivals or to further business objectives can be a worthwhile investment as it might have impressive growth prospects.
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Assess financial valuation ratios
Investors should have knowledge about the price of the shares being offered. They should know whether the shares are overpriced, underpriced or reasonably priced. You can assess various aspects such as price to earnings ratio, debt-to-equity ratio, price-to-book ratio and return on equity to analyse the financial valuation. These evaluations will also help with the perspective of portfolio diversification which will help mitigate the risk and offer higher chances of profitable returns.
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Analyse your risk tolerance & financial goals
This is the most critical part of an IPO analysis. Before you make your decision, you need to make up your mind about your investment goal and risk appetite. Do you want to invest for income or growth? Is your risk appetite high, low or moderate? Answers to these questions will help you identify your risk tolerance and financial objective.
You should always invest in IPOs of companies as per your investment goals.
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Find out the reason for going public
Finding out the reason for which the company is raising funds will ease your process of analysing an IPO. Learn why the company is going public. Is it to expand its business, launch new products or services, or pay off its debts? If it is either of the first two reasons, you can consider investing in that IPO.
Final Word
Investing in an IPO, especially for the first time, can be an intimidating task. Hence, a guide for performing an analysis of IPO can come in handy. There can be no better alternative to decisions made by thorough analysis backed by substantial data. If you are wondering how to analyse IPO, do keep the above-mentioned pointers in mind.
Also Read: IPO guidelines for beginners