Introduction
When a company that you have been eyeing for a very long time has decided to go public, you may be incredibly excited. And for a good reason. The chance to invest in a lucrative company when it first opens its doors to the public can be a rare opportunity.
But what if it's a new company, and you don't know anything about it offering its shares for the first time? Would it be a good idea to leap into it right away? While an IPO investment can give you a slice of the action, not many may be able to live up to expectations. Hence, it is essential to understand some factors before you click the buy button. Let's look at some critical factors you need to know before investing in an IPO.
Understand Why The Company Is Going Public
There are numerous reasons why a company goes public. But sometimes, it's not all about growth or launching new products or services. A company may use the proceeds from an IPO to repay debt, expand rapidly, or acquire smaller firms — all these come with some execution risk.
Experts say that companies that use post IPO proceeds to repay debt may underperform in the short run. On the other hand, companies that use IPO funds to expand, grow, launch new products and services, use the funds for mergers and acquisitions etc., may do better. Or a new company going public may be out to launch new and unproven technologies. Whether these pioneering new services may gain traction in the long run, is an aspect you need to study before investing in. Hence, researching the company will give you a thorough understanding of how the company will utilize your investment.
Watch public emotions
There are some who like to be among the first to get their hands on a new product or technology, see a new movie,; buy a new phone and so on. This first-mover impulse is also applicable when any high-profile company issues its shares for the first time. The human desire to be among the first investors in the next MRF or TCS can be palpable, especially if the hype around the company is high. In some cases, the attention may be warranted, but it could also be a bubble waiting to go bust. Hence, a vital factor to keep in mind before investing in a new IPO is to focus on the reasons you want to invest in the first place. Establish a clear and strategic reason to purchase the shares and check off the herd mentality or dramatic mood swings to stick to your research and analysis.
Get to know the company
Well-known and established companies that have been publicly trading for decades have massive data regarding their cash flows, balance sheets and capital allocation strategies. So this gives you in-depth insight into the strengths and weaknesses of the company. It also provides analysts with in-depth information on forecasting earnings. But with an unheard-of company that's going public for the first time, there's not much data to study. That means the share price and market sentiment can shift dramatically when these companies begin to report results. This is mainly because investors and analysts are still trying to understand how the management is operating.
Look into the draft red herring prospectus (DRHP) that companies file with SEBI before they go public. This prospectus contains a basic overview of the company, how it plans to use its proceeds or raise capital, the risks to its business models, and an overview of the company's financials. If you're planning to invest in an upcoming IPO, the company's DRHP should be on your reading list.
How It Fits In Your Plan
Investing in a new public company that you're excited about can be a lucrative investment opportunity. However, like every investment, a new IPO is also risky. In fact, a fresh IPO may have additional risks that could distort the price in several ways. But knowing the risk factors and how they could drive stock volatility can help you understand whether it fits in your overall investment profile. It's important to understand why you are investing in the company in the first place. How will the upcoming IPO investment factor into your overall financial plan and aspirations for your goals?
Conclusion
In your quest to build long-term wealth, you need to balance risk and reward strategically. Having a well-diversified investment portfolio that comprises stocks across industries, geographies and sectors, and fixed income securities, real estate, commodities, and other assets can help you balance risk effectively.
Investing in a potential IPO does not require you to sacrifice portfolio diversification. Hence, develop the right investment strategy and stick to it based on your risk profile, time horizon and long-term goals. If you're looking to build a cohesive investment strategy, speak to a financial advisor who can show you how your investments fit into your plan. You can get all the information you want and the financial knowledge you need to get to your financial goals one after another.