Are all IPOs worth investing in?

Lakshya Kumar is a young banker and considers himself a DIY investor. He prefers to invest in direct equities and Initial Public Offers (IPOs). He believes that investing in such stocks is a good way to create wealth. India witnessed a fair share of IPO activity last year. There is more of it happening again in sectors unaffected by the pandemic. Since the market sentiments have improved over the past three -four months, many more IPOs are lined up. However, the real questions for Lakshya are – which IPOs are really worth investing in and what factors should he keep in mind before investing?

When investing in an IPO, it is important to understand that it is akin to investing in the growth of a small company, a sunrise industry, a large corporate opening up to retail investors and being a part of its growth journey. Hence, it is important to take a good look at the company, the nature of business, its track record, management, competition, and its business outlook. A company in the growth stage may offer more potential for long-term capital appreciation. This information is usually available in the company’s ‘red herring prospectus’ which is a document that contains information about the issuer (the company offering shares for public subscription).

The valuation and the attractiveness of the IPO price band can be analysed by reviewing the financials of the company, referring to research reports or by comparing with the valuation ratios of similar companies. This will give Lakshya a holistic view of the company’s prospects and help him understand if the IPO is overpriced, under-priced or fairly-priced.

However, valuing the company even by comparing ratios with those of peers, is easier said than done. An easier way to do that would be to check if there is over subscription in the institutional/non-retail segments. If yes, it means the demand for the IPO is high. Smaller or growing companies may raise capital for several purposes, such as expanding to new markets, research and development purposes, paying off debt etc. Usually, those pursuing a growth strategy offer a better bet for gains from an IPO perspective. It is prudent to study the potential utilisation of IPO proceeds. In addition to referring to the prospectus and other aspects, it would be advisable to study the grading for IPOs that credit rating agencies have to offer. An IPO grading of ‘4’ and above may possibly be a better choice.

Lakshya should understand that he is ultimately investing in a company and all market risks associated with equity markets will apply. Further, there are risks where the IPO may not be fully subscribed which may entail a dip in the share price as compared to the price band.

There is also a risk that the IPO may be over-subscribed many times and he may not be allotted shares. He must be mindful of the ‘noise’ that may be prevailing in the run up to the IPO and cut through the chatter and the material aspects of the company’s potential.

(Content on this page is courtesy Centre for Investment Education and Learning (CIEL). Contributions by Girija Gadre, Arti Bhargava and Labdhi Mehta.)