InvestorQ : What are the key factors that I need to check before investing in an initial public offering (IPO)?
Riya Dwivedi made post

What are the key factors that I need to check before investing in an initial public offering (IPO)?

rhea Babu answered.
3 years ago

Actually, there rare are a large number of factors that you need to check but all these can be effectively summarized into a set of five points as under:

Thanks you for diversification but I would prefer a focused business model

Gone are the days when large companies could expand and diversify just because they had surplus cash. Now you can only add capital if the business adds shareholder value. An IPO is just like buying in the secondary market because you are buying the business not the stock. You obviously want the business to be focused rather than a holding company type of business that is dabbling in a lot of unrelated areas. That is exactly what happened to Cafe Coffee Day. It had interests in coffee trading, coffee retailing, financial services etc. The real outperformers were highly focused plays. VRL focused only on logistics, Syngene on research, Interglobe on aviation, D-Mart on retail and Dr. *** Pathlabs in laboratory testing. Ideally, put your money into IPOs that have focused business models and an established track record. They are more likely to work in your favour.

How is the company going to use the IPO proceeds raised?

You don’t want your hard earned money to be squandered by the company. This is a lot more critical than it appears to be. Ask your advisor some serious questions about how the funds are going to be utilized. In the past, there have been umpteen instances of IPOs that were raising funds just because it was available. Similarly, raising an IPO for repaying debt is not a great idea because the cost of equity is higher than the cost of debt. Thirdly, don’t focus on companies that raise IPOs to finance their working capital needs. That is a classic case for a maturity mismatch. You need to put money in IPOs where funds are being raised for expansion, capital allocation or acquisitions that are genuinely likely to improve the ROI in the coming years.

Are the promoters and anchor investors exiting via the IPO?

To be fair, promoters need to monetize part of their holdings at some point of time as do anchor investors. The problem arises when the promoters and anchor investors take a substantial exit through the Offer-For-Sale (OFS). IPO investors count on anchor investors to provide continued guidance to the managements over a longer period of time. A substantial exit by promoters and anchor investors via the OFS does not inspire confidence in the investors and you must approach such IPOs with caution.

Go through the fine print because the devil, often, lies in the detail

The prospectus is an important document and as an investor you need to go through it in detail. Firstly, check if the IPO is substantially diluting the EPS of the company. A golden rule is to avoid IPOs of companies with a very large capital base. They will always struggle to grow their EPS and create ROI for shareholders. Secondly, be cautious if the projections are too aggressive. You must put money in a prudent business not in a sales pitch. Lastly, do some background checks on the promoter background through Google and the MCA website. In an era of widespread information dissemination, it is not too difficult to do a smart background check of the promoters. That matters a lot!

It is all about adding value without too much leverage or too much dilution

Firstly, value creation is all about growth. It is one thing if you want to just exit on listing, but it is another thing if you want to hold on to the company. In that case, ensure that the company is in a sector with adequate growth potential. Secondly, we have already spoken about preferring companies with smaller equity. Such companies are better positioned to create value and growth. Lastly, avoid companies that have a huge debt burden hanging around the neck. These are the most vulnerable to industry and macro shocks!

You must look at the IPO in the same way as you look at the secondary market purchase. But first get over the myth that the IPO is a short cut to making money. IPOs can cut both ways.