Things to Check Before Investing in IPOs
Lately, the trend of investing in the latest, much-talked-about Initial Public Offerings (IPOs) is upsurging significantly. While this investing opportunity may seem appealing, when it comes to deciding the best one to put the money into, it is not always a cakewalk.
Consider it this way: you must choose which new company to invest in the same way you select your career. You must begin with thorough research, spend a lot of time analyzing, evaluate the pros and cons, and determine whether you will get satisfactory returns.
It does not end here. This post contains a comprehensive checklist that will help you choose the best IPO cautiously. Let’s get started.
Introduction of IPO & History
An Initial Public Offering is a public offering wherein a firm’s shares are sold to individual and institutional investors. With the help of this process, a privately held corporation goes public.
It is generally raised to acquire funds for:
- Equity capital
- Monetizing investments of private equity investors or private shareholders
- Allow hassle-free trading of future capital or existing holdings
All the information about this offering is disclosed through a prospectus document.
Talking about the history, the earliest establishment that issued public shares was Publicani, during the Roman Republic. However, this claim is not accepted by every modern scholar. The Publicani were, much like modernized joint-stock organizations, legal bodies, autonomous of members whose possession was divided into parts (shares). According to the evidence, these parts were traded and sold to public investors in the Forum in an over-the-counter market near the Temple of Castor and Pollux.
In America, the first IPO was that of the Bank of North America in 1783. In India, Reliance Industries Limited (RIL) came up with its initial offer in 1977.
Things to Keep in Mind Before Investing in IPOs
Now that you are ready to invest, here are a few things that you must keep in mind:
Read the Red Herring Prospectus
According to the SEBI guidelines, every business going public must file the Draft Red Herring Prospectus (DRHP). This prospectus outlines the following information:
- Its foundational overview
- How it is planning to proceed with raising capital
- The risks associated with the business model
- Organization’s business plan
- Every business operation held within the corporation
- Information regarding the promoters
Whenever a firm decides to go public, the market starts buzzing and talking about the its quality. Being an investor, you must not take a step based on hearsay but conduct your research. Thus, this document will be extremely crucial for you as it contains in-depth information about the firm you must know before putting your money in.
However, you will not be able to find information regarding the IPO in this document, be it the number of shares available or the price of shares. Keep in mind that this document should comply with the prospectus. If you find any difference between the two, don’t forget to bring it to everybody’s notice.
Know Why It Is Raising Funds
A business might decide to go public and raise funds for various reasons. However, it is not related to launching a new product or service or growth in some situations. It can also raise funds to acquire a smaller firm, expand speedily or repay debts. And these reasons come with some hint of risk.
As per the experts, companies using the capital market route to repay debt might underperform in a few years. On the contrary, the ones going public to launch new products or services, grow, expand, and use funds for acquisitions and mergers might perform well and provide steady investment opportunities.
In case, it is coming up with a pioneering product, analyze whether this technology will acquire traction in the long run or not. Accordingly, you can make an investment decision.
Thus, you must know and understand the intention behind raising capital. Moreover, you can also evaluate its position in the market to figure out positive and negative indicators. More importantly, stay mindful of anything that will benefit third parties, like extra fees paid to advisors.
Company Strength and Market History
Before you move ahead with investing in an IPO, you must conduct a Strength, Weakness, Objective, and Threats (SWOT) analysis. You can easily evaluate the weaknesses and strengths of a business from the DRHP. You must figure out its position in its operating sector to make the right choice.
Try and read about it from a myriad of sources. Also, dig deeper into the strategies adopted by them so you can study past and future prospects. Get to know the financial history and asses its performance over the last years to understand how it has been growing. With this, you will also be able to discover the exact reason why it is choosing to go public and where the money will be used.
Studying the valuation is another important factor you should consider when investing in a business’s initial offering. The best and easiest way to do the same is by comparing the return on equity and its price-to-earnings ratio with its competitors.
To calculate return on equity, you can use the following formula:
Net income/equity of the shareholder
To calculate the price-to-earnings ratio, you can use the following formula:
The share price of the stock/earnings for every share
Evaluating the business’s financial data can help determine its financial health and growth capacity. For instance, if you wish to evaluate the extent of leverage that is being used, you can use the debt-equity ratio metric.
If the debt-equity ratio is high, it will signal a higher risk that the lenders and investors of the establishment will have to face, as it means that the firm is using large amounts of borrowed money to achieve growth.
Further, the cash flow, return on capital employed, Earnings Per Share (EPS), and more such metrics can help you make the right decision. For you, it would be best if you avoid investing the money if the firm’s financials don’t hold any significant comparability with its competitors and if the valuation turns out to be weak.
Higher Best Promoter
One of the critical factors to evaluate is the promoter. These entities can either be an individual or an organization. If the corporation going public has hired a recognized name, it will surely add a sense of credibility to the entire issue; thus, a premium will be added to the price too.
Additionally, the valuation is further boosted when a government associate promotes it or if it is government-owned. Experts recommend getting back to the history of the promoter and finding out the number of years they have spent in this industry. With this, you will get an idea of how many successful IPOs they have had, which will help you evaluate the success rate of the current scenario as well.
Understand the Risk
When you invest in the stock markets, you must be wary of the fact that there is always some risk involved. Considering the extensive range of organizations across industries and the experience that each one of them holds, comprehending the risks pertaining to every business is a crucial step that should be taken before investing.
The present market environment, quality of products or services, and the number of competitors are a few of the many aspects that play a part in helping you understand the risk factor. You can go through the prospectus to know more about the specific risks it is facing in the market before investing in it.
Why Companies Announce IPO
Here are some of the most common reasons why companies go public:
To Raise Capital
One of the prevalently common benefits of hitting the bourses is to raise capital. While other methods available can help with this purpose, they could be riskier than going public. By going public, it can acquire a lump sum amount that can be used for several objectives.
To Be Known in Market
By launching an initial offering, the enterprise can easily acquire more credibility and visibility. The fiscal data becomes more transparent, and it can easily fulfil the requirements of SEBI by reporting frequently. It can also expand its market knowledge by going public and making changes to achieve growth accordingly.
Pay Back the Capital
When a firm is in debt, whether it is loans taken by a bank or individual lenders, going public helps to garner wealth that can ultimately help with capital payback. Banks provide restricted funding if it applies for an additional loan to repay debts. Also, interest rates are higher as well. Thus, going public saves companies from all such troubles.
Modes Through Which You Can Apply IPO
There are two different ways:
Demat Account / Trading Account
This is an effortless online method where you must use a Demat account or a trading account. If you don’t have any of these accounts, you can get one opened from a financial institution that offers initial public offering application facilities, such as Upstox. Once done, you can apply for the chosen the initial offering by logging into your account.
You can apply for offline with the help of a bank account. You will have to visit the nearest bank branch and fill out the ASBA form there. Also, you will have to attach KYC documents along with the form to complete the procedure.
Why do Companies Open IPO to Pre-Apply?
A pre-IPO is the same as an Initial Public Offering, as it allows you a chance to buy shares. But that is the only similarity there. A pre-IPO takes place in a private and not in a public one. There is only a possibility that it can go public someday, but there is no guarantee.
With pre-IPO, it lets you enter the organization earlier and buy shares at a discounted price. After the initial offering, if the business is well-established, the stocks are closed at a much higher price. Thus, there are more potential rewards here.
Frequently Asked Questions (FAQS)
How does anyone know if an IPO will do well?
To determine whether it will do well, you will have to wear your researcher’s hat and dig deeper into their past, present, and future plans. Try to look at the numbers that it has been acquiring for this while. Also, understand its business model and compare its performance with its peers.
Investing in pre-IPO good or bad?
Investing in pre-IPO comes with its own set of pros and cons. One of the biggest advantages is that you get to be a part of the firm much earlier. This way, you can get shares at a discounted price. However, on the other side, there is less transparency and more risk with no guarantee of whether it will ever go public.
How to invest in it?
There are two easy methods to invest in an initial offering. You can choose the online or offline method. In the former, you can apply through a Demat or a trading account. In the latter, you can apply by visiting your bank’s branch.
What is IPO in the stock market?
It simply means the business is ready to sell its shares to the public. In simple words, its ownership goes from private to public.
What is IPO buying time?
It begins at 10 AM and ends at 5 PM. The application closing time varies from bank to bank.
When can a corporation go for IPO in India?
It should list itself on any recognized stock exchanges for a minimum of three years to go public. Its net worth should be a minimum of Rs. 1 crore in the last three years. Also, its average operating profit should be Rs. 15 crores (pre-tax) for three years.