How First Time Investors Should Approach the World of IPOs

The Reserve Bank of India (RBI) in its state of the economy report said 2021 could be India's year of initial public offerings (IPO).

Well, turns out that's true not just for India, but for the rest of the world as well.

So far in 2021, a total of 1,821 IPOs have come out globally. Of this, 106 have come out in India.

By the end of 2021, another 10 IPOs are expected to list on the bourses in India. The total funds raised through these IPOs is expected to reach Rs 1 tn.

The Indian IPO market in 2021 is not just different due to the number of IPOs, but also due to the enormous amount of participation it has seen from retail investors.

In the financial year 2021, a total of 14.2 m new investors participated in the stock markets. In the first quarter of the financial year 2022 alone, 7.1 m new retail investors became a part of the financial market.

To a new investor, IPOs look extremely promising. The listing gains are huge and offer a great opportunity to make money in the short term.

But here's something you need to know before investing in an IPO, whether you are a first-time investor or not.

IPOs can be very risky.

Keeping the risks in mind, here are a few points you can consider before investing in an IPO.

#1 Define your objective

Before investing in an IPO, it's important to define your goals.

Are you applying for listing gains, or are you looking for a prospective candidate for your long-term portfolio?

Some IPOs can give excellent listing gains, while some may list at a discount initially, but can be an excellent pick for a long-term portfolio.

Take the case of Zomato. It gave close to 65% returns on the listing day. For investors looking for short term gains, this would've been an excellent opportunity.

However, since its listing in July 2021, the shares of Zomato have fallen. They are now up by only 12%.

On the other hand, shares of Anupam Rasayan India listed at almost 5% discount to its issue price in April 2021. However, the company's shares have zoomed 70% in the last eight months.

You cannot predict whether an IPO will list at a premium or a discount. It depends on multiple factors.

But if you are a first-time investor, it's always better to invest for a long-term horizon. This will help you ride out the volatility in the short term.

#2 Understand the business

Warren Buffett said, 'Never invest in a business that you don't understand'.

For a listed company, there are endless sources of information. But for a company that is not public yet, the draft red herring prospectus (DRHP) is the gold mine of information.

By reading the DRHP you can identify a businesses' strengths, potential opportunities, and risks. You can also gauge how the company might perform in the medium term and long term.

If a company's business model is beyond your understanding then tracking its progress will be difficult.

FMCG companies such as Nestle have a simple business model which can be easily understood. They earn revenue by making and selling consumer products. You can easily track the growth of such companies.

However, new age tech companies like Zomato have complex business models.

Zomato leverages technology to deliver food to your doorstep. It also offers other services like listing restaurants and their menus for people to dine out.

The backend processing that takes place in terms of technology and coordination of manpower can be confusing to understand for some. Hence, tracking the growth of such businesses is difficult.

Do not invest in any business that you find confusing.

#3 How is the company going to use the funds?

Every company has to disclose why it is going for an IPO and how it will use the funds.

You will find this information in DRHP under the 'Objects of the Issue' section. Here the company will explain in detail how they plan to use the funds.

Why is this knowledge necessary to you?

There are two reasons...

First, it's your money. Thus, you're entitled to know how it will be used.

Second, by knowing how the company will use the funds, you can ascertain the sustainability and viability of the business.

Try to gauge whether the company is using the funds for growing its profits or not. If yes, then you can evaluate it further to check if it's a good investment.

#4 Why are existing shareholders selling their shares?

When a company goes for an IPO, it's often because existing shareholders intend to sell their shares rather than raise funds through a fresh issue.

In such a case, all the proceeds go to the promoters and not the company. Hence, you have to be extremely careful before investing in such companies.

You can start by asking yourself why are the existing shareholders selling their shares?

Sure they might be booking profits. But you can always get a sense whether they are exiting to take advantage of a high valuation.

Take Paytm for example. More than 50% of the funds raised by the company were through an offer for sale by existing shareholders.

The market also thought the issue was overvalued. This resulted in the company's shares listing at a discount to the issue price.

#5 Look at the company's financials

This is the most important section for any business.

In the DRHP, you will find information about the company's profitability and financial position under the 'Financial Information' section.

Why do you need to look at the company's financial statements?

By studying the financial statements, you can see how much revenue the company is making, how much it's spending, and how much profit it's earning.

A profitable business has higher chances of surviving in the long run than a loss-making one. If a company's financial profile is strong, the shares will automatically perform well at the stock market.

Take Paytm for example, the company has consistently reported losses in the past five years. As a result, the shares of the company have performed poorly despite it being a popular brand.

The popularity of the brand doesn't determine its performance at the stock market. Its fundamentals do.

Look for a company with strong fundamentals and a robust financial profile to invest in.

#6 Valuations

You might have read analysts' reports that say, 'The IPO is valued at Rs 200 m'.

What is this Rs 200 m?

It's the value of the company. A company hires experts to value its business based on performance and other factors.

But what does it mean for investors?

In value investing there is a concept called intrinsic value or true value. This measure determines the actual worth of a business. Based on the intrinsic value, you can determine whether the IPO is overvalued or undervalued.

An undervalued stock means, it's underrated by the market. In other words, the company's shares are trading below their actual value.

This means the stock has good growth potential or upside and minimal downside risk. It's better to invest in an undervalued business as it offers a margin of safety for investors.

#7 Management background

It's very important to check the background of the people running the company. Promoters and management are the main pillars for the company. They are the ones who will take the company forward.

A company with a strong management team indicates better prospects of future growth.

Take the case of Hindustan Unilever.

The company has been known to have a solid management team and one that follows good corporate governance practices.

The same can be seen in its ever growing share price.

On the other hand, companies such as Satyam saw its share price crash due to a fraudulent management.

To conclude...

Investing in IPOs is a risky affair.

Thirty out of the 106 IPOs listed so far have listed at a discount to the issue price. Many have done well too but you never know how the company's shares will perform in the long term.

Take the case of ICICI Lombard. It listed at a discount of 2%. However, in the last four years, the company's stock has doubled.

If you had exited the share on a listing day, you would've incurred a loss and also would've missed out on a huge long-term profit.

In a volatile IPO market, new investors end up taking the wrong decision in the heat of the moment. Don't let that happen to you.

Participating in the stock market can be very exciting. But don't let your emotions get in the way of your decision making.

When investing in an IPO, it's always better to do your research and proceed with caution.

Happy Investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more here...