Five factors to watch out for before investing in an IPO

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Highlights

  • Investors with excess liquidity subscribe to all IPOs regardless of the fundamentals of the company
  • The focus of investors has shifted from long term to short term.
  • A strong business model and healthy business finances are more important than the first-mover advantage.

New Delhi: In 2021, many companies joined the initial public offering (IPO) movement to capitalize on the investor frenzy and demand exorbitant premiums from investors. Investors, overwhelmed with excess liquidity and in the absence of any other investment opportunity, rush to buy these primary market offers despite high valuations in order to make quick money from the price gains. Investors ignore many aspects such as the fundamentals of the business, the revenue model, the cost structure, its position relative to its competitors in the same industry, the various business risks and the valuation. The focus of investors has shifted from long term to short term.

It should be mentioned here that the quotation gain that we see in a particular IPO is related to the subscription amount. The more an IPO is written, the more the chances of listing increase as gray market activity increases. This is evident by looking at recent IPOs. (See the table below).

Company Name SEO gains (in%) Number of times subscribed
Tatva Chintan Pharma Chemistry 95 180.36
Rolex rings 39 130.44
Devyani International 57 116.70
Nazara Technologies 79 175.46
Metallic Shyam and Energy 20 121.43
Clean science and technology 98 93.41
Jewelers Kalyan India -15 2.61
Suryoday Small Finance Bank -4 2.37
Macrotech Developers -ten 1.36

Source: nseindia.com

However, experts say that in the long run, what matters is the company’s actual financial performance. Listing gains may not last two to three quarters if the company fails to justify the gain by its financial performance. Investors should therefore examine the fundamentals of the company before requesting an IPO rather than just looking at the listing gains. Here are five factors investors should watch out for before applying for an IPO.

1) Understand the core business of the company: Investors need to understand what the business does, what its business model is, how it generates revenue, what the cost structure of the business is. Another thing that needs to be understood is whether the company has a scalable business model or not. You should also understand if there is a risk of obsolescence of the company’s products / services. Can the company adapt quickly to technological developments in the sector? Once you get a clear answer to these questions, only you should invest in an IPO.

2) Look at his finances: Each company that files an IPO submits a DRHP (draft prospectus on red herring) to the Sebi. In the DRHP, the company provides its financial statements for at least the past three years. Investors should see if there is a clear trend in its revenue, profit and operating parameters such as net profit margin, operating margin, debt ratio, etc. If the company’s income and profits have steadily increased over the past few years, it makes sense to invest in the business. For a loss-making business like Zomato, you should see if their income is growing steadily or not. A strong business model and strong financial data are more important than the first-mover advantage.

Some other financial parameters that the investor should look at are positive and increasing free cash flow from operating activity, low debt to equity ratio and debt reduction, unexplained increases in income and profit l year of the IPO, huge debt and other liabilities and the presence of many business-to-business transactions.

3) Objective of the IPO: If the public issue is intended to raise new capital, which the company plans to use to develop the business, it is more reassuring for an investor than a company that only goes public to give the exit first investors and private equity funds.

4) Check the contingent liabilities: If the company has an ongoing legal action against it over the patent or rights issue or anything else, it may lead to possible liability if the company loses the lawsuit. Also check if there is a complaint against the company regarding fraud, controversies etc. High compensation for management and promoters as a percentage of income is also a warning sign that investors should be aware of.

5) Compare the company’s financial data with that of its rated peers: When analyzing a company’s financial data, investors should compare it with other listed companies. The company’s price / earnings ratio to peers’ PER should be compared to the company’s growth prospects. It can be noted that a mature business will trade at a low PER compared to a business in the start-up phase and still growing. It is also necessary to compare the return on capital and the price-to-book ratio of the company with its peers.

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