In the last 3 years, IPOs or Initial Public Offerings have once again emerged as a veritable investment for small and large investors. While the current fiscal has been relatively tepid, the last two years saw $2 billion and $8 billion respectively raised through IPOs. The story of IPOs in the last 2 years has been one of competitive pricing and attractive post-listing performance. Big names like Alkem, Shankara Building Products, D-Mart, ICICI Pru Life, SBI Life and GIC Reinsurance have all contributed towards the credibility of the IPO market. The big question in front of investors is how to evaluate an IPO and what to know before investing in an IPO. Let us look at some of the critical factors.
Vision of the IPO issuing company
This can be quite subjective but there are a variety of sub-factors to consider. You must first understand how the industry overall is changing or how it is being disrupted. More importantly, you must check how the company is preparing for the disruption. Does the company have a crystal clear vision to attain leadership in the particular niche in which they are operating. Value is normally created by the top two companies in any business, not by the others. Also-ran companies can never create long term value.
What is the background of the promoters
Wealth creation in equities is all about intangible factors like corporate governance, transparency, standards of disclosure etc. These may sound like abstruse concepts but they have a direct bearing on the valuations of a company and the performance of an IPO. Check the background of the promoters and their past track record in the business. Check the contingent liabilities section to understand if there are major legal cases pending against the promoters. Today with centralized databases, it is possible to check the background of the promoters through the MCA website. It is the promoters who are the final difference between a bad company and a good company.
Is the company being valued too aggressively?
At the end of the day, it does boil down to valuations. Valuation is measured by the P/E but it is not just about P/E ratio alone. For example, D-Mart was relatively expensive when it came out with an IPO year but it has still managed to generate over 400% returns post listing. Apart from the P/E ratio, the growth prospects matter for valuations. You must be extra careful of companies that try to use the IPO as a means to exit at rich valuations.
How are the funds from the IPO going to be utilized?
If it is a manufacturing company and the company is using the IPO funds to expand its scale or to make strategic diversifications then it is a good idea. This will enhance the long term prospects of the company. You must be fully wary of companies that are likely to use the proceeds of the IPO for investing in real estate and office space. Thirdly, repaying high cost loans with IPO proceeds is understandable but equity has a higher cost compared to debt. If IPO proceeds are going to be used to finance working capital gaps then it is a clear red flag and you must be extremely cautious.
Is the IPO Company caught up in legal wrangles?
This is normally part of the fine print. Be careful here because some of the small cases can snowball into bigger issues. Legal cases, corporate governance problems, business challenges; risk factors are all hidden in the fine print and they all can be potentially damaging. Legal wrangles are part of the story, but reading the fine print will enable you to unearth a lot of hidden wisdom hidden in the form of fine print.
What is the promoter holding post the IPO?
Does this really matter? Actually it does matter a lot! Many promoters will be looking to monetize part of their stake as part of the IPO. This is true of companies promoted by large institutions as well as entrepreneurs. Be wary of companies where promoters have been trying to consistently dilute their stake in the company. This is not a good sign at all. The historic evidence has been that when promoters are themselves not too committed to the company that the performance is likely to falter sooner rather than later. Post holding of promoters shows their commitment to the business.
High debt companies are rarely wealth creators
The one thing you need to really look at is the debt levels. There is financial risk in debt and that is where most mid-cap and large cap companies falter. If you look at the out-performers in the last 10 years, they have all been companies with low levels of debt. And who are the wealth destroyers. They are typically the high debt companies like Jaypee, GMR, GVK and ADAG groups. These companies have faltered badly as too much debt has pushed them down. Too much debt to begin with is a clear red flag in any IPO prospectus.
Are there impressive anchor investors?
OK, this is not a very serious issue but merits attention, nevertheless. The anchor investors are large institutional investors who have participated in the equity of the company even before the IPO. Anchor investors bring credibility to the IPO. It shows the degree of faith reposed by institutional investors in the issue. Normally, these anchor investors provide stability and credibility to the company and it is favourable for valuations. Of course, don’t give too much credence to this point.
At the end of the day, the proof of the pudding lies in how the company performs post listing. A quick check of the above 8 factors will ensure that you do not become a victim of slick marketing. IPOs work both ways. IPOs have created value for shareholders but they participate in market excesses. That is exactly where you need to draw the line! Get more info here.