Investing in an Initial Public Offer (IPO) at lower prices and making a fortune by selling at much higher prices is a beautiful dream every investor has. But this can turn out to be a nightmare if your money is not invested in the right IPO at the right time. Although if you follow some good tips to invest in IPOs before making a decision of buying, the chances of winning can be enhanced significantly.
Let us discuss some of the most important tips to invest in IPOs.
The first tip to invest in IPOs is the key to self-belief. Before listening to anyone else about whether to invest in a particular IPO or not, please make sure to research on the internet about any and every information about the company like:
Company and its competition in the market
The previous financing obtained by the company
Overall condition of the sector to which the company belongs. For example Pharma, automobile, oil, etc.
Your research may reveal that the IPO is being overhyped and you would be better off without making this investment.
Also, the most important thing to see is the price at which the shares are being offered to the general public. PE (price to earnings) ratio of the company must be seen and compared with industry standards. Generally, it can be said that a PE ratio > 25 is a warning sign for investors.
Try to find IPOs backed by strong stockbrokers:
This is an important tip to invest because a big and reputable broker would try to be associated with good quality companies.
However, there is one benefit of a small brokerage house. Small brokerage houses have a small client base and thus, it is easier for individual retail investors to buy pre-IPO shares.
DO Read the Red Herring Prospectus:
This tip to invest in IPOs is a lot of hard work but totally worth doing. A Draft Red Herring Prospectus is an offer document which contains all the necessary details about the operations and financials of the company going public. Some of the information mentioned in the prospectus is listed below:
Details of the promoter
Reasons for going public
Use of proceeds of the IPO i.e. ways of spending the money raised through IPO
Risks involved with investing in the company
It is the most important tip to invest in IPOs which must not be neglected under any chances. According to the Securities and Exchange Board of India (SEBI), it is mandatory to file a DRHP before going to the Registrar of Companies.
SEBI reviews the offer and gives its recommendations to take necessary modifications in the document until it is completely satisfied. Finally, when all the changes have been made recommended by SEBI, the offer document is published for investors which can be accessed at various places like:
Website of the merchant banker associated with the IPO
Stock Exchange websites
Website of SEBI
Now, let us examine what all sections of the prospectus should be given extra special attention in the below-mentioned points:
Objects of the Offer:
As the name suggests, it gives information about the intentions of the offer. If the major reason of the IPO is to provide a partial/complete exit to its early shareholders, then, one should view it with scepticism.
An analysis of the balance sheet will provide us with a fair good knowledge about the financial condition of the company. Some things in the balance sheet depict the true picture of the company like the debt of the company. Check out the debt to equity ratio. Too much debt is a matter of concern.
The debt to equity ratio of the company should be comparable to its counterparts in the same sector.
Revenue & Operating Profit:
These two give a good picture of the financial performance of the company. A continuous growth in revenues and profits are the signs of a profitable company which can be expected to give good results in future as well. Any company which has revenues less than ₹200 – ₹250 crores is too small and demands extra caution in making the investing decision.
Shareholding of Promotors after Listing:
Although one of the greatest advantages of an IPO is to provide a means of exit to its early shareholders but still it is an important thing to note. Promoters holding anything less than 25% stake in the company after its listing can be a sign of decrease of their interest in its performance.
This is one tip to invest in IPOs which must be kept in mind every time you are making an investing decision. Do try to isolate your decision making from all the hype brokers and media are creating about an IPO launch. Do not get blindsided by attractive terms like “listing gains”, etc.
If someone is recommending an IPO very strongly, it should sound ring warning bells immediately. Sometimes, brand names succeed in making us biased towards them and it has happened in the past when people even took loans at considerable rates of interest to invest in good branded companies’ IPO.
All their hopes came crashing down with the stock prices of their companies.
For example: In 2008, when Reliance Power was launched, it failed miserably and for the first time in history, the magic of “Reliance” could not happen. Very few could have anticipated such a thing because it was very difficult to think beyond the name of Reliance at that time.
Look Out for the Lock-Up Period:
This tip to invest in IPOs may not seem important but it really is. Lock up period of shares means that there is a legal contract between the underwriters and insiders of the company. Insiders are the ones who own then more than 10% of the company shares.
If they sell their shares after the lock-up period in large numbers, the share price is bound to go down as this would imply that the insiders are not confident enough about the performance of their company.
So, it is advisable to wait for a certain period and let the stock price settle down a little bit before jumping in to invest in the company. A good company will remain good even then.
Plan an Exit Strategy Beforehand
This is a very important tip to invest in IPOs because it may save you from many potential losses. Before investing in an IPO, decide a decent amount of profit you want to gain from it. As soon as the target is achieved, sell them unless you are extremely confident about the future performance of the company.
The first few days of an IPO are very unpredictable. Shares of consistently good performing companies can be bought at a later date also once the share price seems to settle down.
Also, think about a certain amount of loss you would be ready to bear in case the IPO does not work well. Booking a small loss at the right time is a wiser decision than sticking to the stock and ultimately, ending up suffering bigger losses. Managing risk is also a very important aspect of managing finances.
Avoid companies that are still in the process of setting up business:
This tip to invest in IPOs might save you from heavy losses. Sometimes, some companies may reach the stage of IPO without really performing too well in the market. They are bound to betray their investors badly.
One such example where such a thing happened is of Electrosteels Steel. It launched its IPO in 2010 at a stage where they were still trying to set shop. One of the main reasons for their IPO was to set their maiden manufacturing plant. The company had good plans in place but it suffered some execution problems. They finally went bankrupt.
Its IPO price was ₹10 – ₹11 per share which went down to ₹2 per share. Imagine the investors’ plight in such a case!
Look at the Management of the Company
It is a small but powerful tip to invest in IPOs. Good financial performance of a company says about two main things:
Quality of business
Quality of management
Good management plays a pivotal role in maintaining the operations of a company effectively and efficiently. It also has more chances of a bright future ahead as compared to a fairly good company suffering from management issues.
DO NOT get blindsided by the growth rate of a new sector:
The last but not the least tip to invest in IPOs is that one should not forget that the booms of any industry sector are not a permanent thing. Do not over-invest in these sectors because there is always an inherent risk to it. Let us discuss an example for this:
In 2005, wind energy was emerging as the new exciting and hot sector. It was the perfect timing for the launch of an IPO of a company in this sector. Suzlon Energy’s IPO came during that period and attracted lots of interest from a huge number of investors.
And the hopes and dreams of their investors got fulfilled when it showed a staggering CAGR of 72% and 50% at that time. But what goes up, comes down at some point in time. So did Suzlon Energy! And the investors who invested too much of their capital into it hoping for a better future remain disappointed.
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