The IPO market has been throbbing with action in the current year with close to Rs.90,000 crore already raised via IPOs in the year 2021 so far. By the close of December, the total IPO collections are expected to exceed Rs.120,000 crore. Of course, there is still the LIC IPO, but that is only expected around March 2022.
The slew of IPOs are as much a responsibility as it is a privilege to invest in a wide variety of new companies. IPOs give you the opportunity to participate in a company’s growth in the early stages but it also comes with a risk. Most of the IPO companies do not have an established track record and hence the information available about them is limited. You need to heavily rely on the prospectus.
Here is how an investor can go about reading the fine print in the prospectus.
Understand the industry in which the company operates
Every industry has its unique set of dynamics and economics. To understand the value of investing in a cement IPO, you first need to understand the nuances of the cement sector like demand, supply, pricing power, power costs, freight costs, cement demand, regional supply variances etc. This is the starting point when it comes to reading the IPO prospectus. Behind every stock there is a business and behind every business that is an industry ecosystem. Try to grasp that industry ecosystem.
Keep a tab on possible disruptions
Disruptors are hard to find and estimate but they are also the best value creators. Check if the company coming out with the IPO has managed to create unique strengths or entry barriers to fresh competition. Check for likely disruptions to the industry from emerging business models. For example, hotels faced competition from aggregators, traditional cars are facing competition from EVs, offline retail is facing competition from online ecommerce; and the list can go on.
Financials do matter; and they matter a lot
Look for the sales and profit trend for the last 3 years and also of the last 6 quarters. More than spurts of growth in profits and sales, look for consistency of performance. That is more of a value creator. Check if the valuations are in line with peer group based on current and projected earnings. This may be a tad complex in digital IPOs which are mostly loss making. However, you can use proxies like sales, GMV, operating profit etc.
Is there too much of dilution of capital?
This can be a tricky situation. Too large a capital base means equity dilution. For example, if the company has 10 crore shares outstanding, then it needs to earn profits of Rs.10 crore to generate Rs.1 EPS. Think of it that way and the importance of a small capital base becomes evident. EPS is higher for low equity base companies and that is the key to valuations.
Is the company binging on debt?
That is never a good idea for any company and especially for a new company. Be wary of companies that have huge debt. Even if the debt is high, prefer IPOs where the fresh funds will be utilized substantially to reduce the debt burden. The market favours companies with a more manageable debt burden as their risk of insolvency is much lower.
How are the IPO funds going to be used?
This is an acid test of any IPO. The IPO prospectus will mention the usage of fresh funds in detail. Prefer companies that focus on expansion and capital investments as they are likely to be most value accretive. Companies that are defraying debt is also a good choice. Be wary of companies that are coming out with an IPO just for working capital and corporate expenses.
Who are the lead managers to the issue?
That is the support cast that will make things happen for the IPO. Focus on the promoter’s stake in the company post the IPO and ensure they have skin in the game. Be careful of early investors exiting en masse. Check the pedigree of the investment bankers and BRLMs as the ability of the issue to sail through and the public perception depend on the quality of merchant bankers.
Finally, there is a lot of hush-hush about contingent liabilities
They may not be on the balance sheet, but give you an idea of potential risks. Be wary if too many legal cases or regulatory orders are pending. Also be wary of too many promoter guarantees as we have seen in many cases.
Remember, the prospectus has a wealth of information to help you make informed decisions about the IPO.
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