Tips to Choose an IPO for Investing: Do you really want to take part in an IPO but do not know what to look for before investing? Don’t worry we’ve got you covered. In this article, we discuss the important aspects to watch out for before investing in a company. Here, we’ll discuss the key things to look to choose an IPO for investing. Let’s get started.
What is an IPO?
An IPO is a process through which a private company can raise funds through the stock market, transforming itself into a public company whose shares are traded in a stock exchange.
This is a preferred means of raising funds as the company is not obligated to pay interest as in the case of loans, The company however is owned by the shareholders post the IPO. There can be a number of reasons why any company offer an IPO. Here are a few of the top ones:
- To raise capital (financial benefit)
- For funding a new project or expansion plan of the company
- For carrying out new research and development works
- To fund capital expenditures
- To pay off the existing debts or reduce the debt burden
- For a new acquisition
- To create public awareness of the company
- For the group of initial investors desiring to exit the company by selling their stakes to the public.
In addition, IPOs generate lots of publicity for the company and hence helps in creating market exposure, indirect exposure, and brand equity.
Tips to Choose an IPO for Investing – Things to look
At the end of the day taking part in an IPO is just another form of investment. The problem however arises as companies that go for IPO’s are relatively new and there is not a lot of information available about them. In comparison companies that are public have reports, company news, and expert analysis readily available on the internet.
In order to avoid investors falling prey to companies with weak financials, the regulatory authorities have made it compulsory for companies to issue a Red Herring Prospectus (RHP). This prospectus is a summary of the company and provides important details like financial statements, revenue, earnings, risks, etc of the company. It is very important that the prospectus is read carefully before investing
Following are some important factors to look at before investing in an IPO:
— Growth Prospects and financial strength
The value of the company depends heavily on its growth rate so far and the prospective growth rate it can generate in the future. The prospectus gives a track record of its growth in various aspects and annual reports throughout the years. This will help in predicting what the company may achieve in the coming years and if it is worth investing in.
— Promoter holdings
The prospectus also includes information on whether the company is freshly issuing shares or are they an offer for sale which are shares of existing promoters. According to the law, promoters are required to maintain a minimum holding of 20% post issue. But if the promoters are selling a major portion of their business this could be a red flag. Instead, if the promoters decide to hold a significant portion of shares post the issue then it is a sign that they believe in the future of the company and want to be a part of it. Instead of using the IPO as an escape.
— Allocation of funds raised through IPO
The prospectus also gives us information on what purpose the money raised through an IPO will be used for. A good sign would be the company allocating the funds for future growth. On the other hand, if the main purpose of the IPO is to pay off existing debt or buy out promoters then these should be considered as red flags.
— Comparison with competitors
In order to assess the company’s performance, one should also compare the performance of the company with that of its peers in the same industry. The IPO price also may be compared to other companies in the same industry. Based on its performance and price with its competitors, one can assess it is a company is overvalued or worth investing in.
— Beware of the oversubscription trap
It is also very important for investors to rely on their research and not on market hype. Often IPO’s are oversubscribed. An investor must not get swayed by this information as subscriptions often replicate market trends. This means that there are greater chances of IPO’s being oversubscribed in bullish markets than in bearish. Companies being aware of this are looking for the highest valuations to make use of this.
IPO Terms to Know Before Investing in an IPO
Following are some important terms that provide vital information for investing in the stock market. Understanding these terms are crucial to choose an IPO and make a sound IPO investment decision:
1. Size: The size generally refers to the offering size. This is the number of shares offered in the IPO multiplied by the price per share. This shows the amount the company is attempting to raise from the IPO.
2. Fresh Issue: This refers to the new equity shares issued to the public.
3. OFS: Offer for Sale refers to the dilution of existing promoters’ stake which is given to the shareholders. Here no new shares are issued.
4. Opening/Closing Date: It is between these dates that investors are allowed to apply for the IPO.
5. Price Band: This refers to the lower and upper limit of the share price within which the company will offer its shares to the public.
6 Lot Size: In an IPO the total shares offered to the public is divided into lots. In an IPO the investors are not allowed to purchase shares of any quantity. They have to do it in lots. In addition, a minimum and maximum lot size is set beforehand.
For eg. say Company A going public sets a lot size of 10 shares for each lot with a minimum and maximum lot purchase set at 1 and 10 respectively. This basically means that the minimum number of shares an investor can purchase is 10 and the maximum a 100. If an investor wants 65 shares he will not be able to do so. But he can purchase 6 lots which is the closest denomination.
7. Face Value: The face value refers to the original cost of the shares.
In this article, we discussed a few of the key aspects to look to choose an IPO for investing. IPO’s are considered to be riskier than other forms of investment as the information available is limited. But the risk can be limited to a great extent if one makes a thorough study of its prospectus. At the same time watching out for the red flags mentioned above. Happy Investing!
Aron, Bachelors in Commerce from Mangalore University, entered the world of Equity research to explore his interests in financial markets. Outside of work, you can catch him binging on a show, supporting RCB, and dreaming of visiting Kasol soon. He also believes that eating kid’s ice-cream is the best way to teach them taxes.