How to identify good IPOs

How to identify good IPOs

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Following a virtual drought in the last couple of years, the IPO market saw a revival in 2015 with 21 public offers. This contrasts sharply with just three IPOs in 2013 and four issues in the subsequent year. As always, the revival in sentiments has been a mixed bag for small investors which have lost money in some IPOs. Disappointing IPO performances of companies such as Adlabs Entertainment, MEP Infrastructure Developers and Power Mech Projects naturally requires investors to ask the question of how to spot winning and good IPOs.

In a typical tongue in cheek style, we are going to suggest that you visit IPO Central regularly (subscription form on the right!) and follow us on social media to see which good IPOs are open. Since IPO Central is oriented towards investor education, we are more than happy to share the parameters which indicate if an IPO is worth your hard-earned money. Here are some steps to identify good and bad IPOs:

#1. Read prospectus to find good IPOs

IPOs involve unique risks that are different from trading stocks. Novice investors often jump on any IPO that comes along. For an IPO investor, it is necessary to know about business prospects and operations of a company. Other factors that need to be considered include management track record, risks involved, and purpose of raising funds to name a few. An in-depth scan of red herring prospectus (RHP) often throws important pieces of information around these points. This one cannot be emphasized enough. 

How to identify winning and good IPOs

#2. Check pricing and peer valuation

Pricing in absolute terms does not mean anything. An IPO at INR10 per share may be expensive and another one at INR50 per share may be inexpensive. Pricing is of utmost importance but needs to be seen along with profits and business growth. The stock market is a forward looking mechanism and is often willing to pay a high premium for companies that promise huge growth. During bull-runs, promoters tend to price IPOs at steep valuations leaving little or no money on the table. There has to be some margin for error and indicators like grey market premium (GMP) vanish quickly if something bad happens in global markets.

Thus, it is critical for investors to avoid applying in IPOs with steep pricing and peer valuation is very helpful in ascertaining this. By comparing various valuation metrics such as price/earnings ratio, it can be checked if a particular IPO is overpriced or not. Despite being a strong brand and showing business growth in years leading to IPO, S Chand failed to deliver returns for IPO investors. It was a clear case of stretched valuations as another equally successful listed peer Navneet Education was available at lower valuations.

Read Also: Here is why you should consider opening a Free Demat Account

Many IPO investors apply for listing gains but there is merit in the argument of having a high degree of comfort level with the space one is going to make investment in. Just in case market sentiments turn weak and the shares actually list at a discount, an investor should be able to hold the shares for sometime (we recommend at least six months). It would be a perfect recipe for disaster if a risk-averse investor decides to invest in the IPO of a fledgling technology company.

#3. Look for the company’s competitive positioning

Factors like past performance, number of years in business, and growth prospects can offer valuable insights in identifying good IPOs. Market share is another great indicator, more so in emerging sectors where profits may still be far. Going forward, a number of e-commerce players are expected to tap the primary markets. Most of these companies will not be profitable as is the case with Infibeam. However, a leading player in its sector cannot be discounted solely on account of loss-making operations.

Often, IPO-bound companies claim there are no comparable businesses like theirs to justify high valuations. Except a few instances such as an IPO by a stock exchange, such claims fall flat. Even in cases where there are no listed peers available in an industry, parallel examples may exist in other industries.

#4. Promoters of good IPOs have skin in the game

Promoters need to have a skin in the game. If promoters of a struggling company are among sellers in IPO, it is hardly inspiring for retail investors. Similarly, IPOs with a heavy Offer For Sale (OFS) component may not be best investment for small investors. After all, why would an investor like to exit a growing business?

It needs to be mentioned though that a little more analysis is required in the case. Private equity investors are not promoters and thus, need to sell out after 4-7 years of making their investments but these investors exiting completely is generally a sign of offers that are not good IPOs. On the other hand, if a prominent external investor decides to stick around in a profitable business, even though selling some stake, it is a sign of confidence that there are better times ahead.

#5. Avoid companies which are too generous to promoters

Businesses are supposed to make money for shareholders and it doesn’t take long for things to become ugly if promoters happen to be ONLY shareholders. Promoters often end paying themselves too much either directly or indirectly and this is never a good sign. The problem is particularly pronounced in the case of first generation entrepreneurs. Internal controls are often weak in such cases as promoter and business often become synonyms.

If promoters have sucked profits out of a business in the past, there are strong chances that they will figure out ways of doing the same after the IPO. There are a number of ways of doing it and investors can do well by avoiding companies which have been too generous to its promoters in the past. It can take the form of remuneration not linked to performance, excessive dividend or a web of related companies which supply goods or services at high prices.

Examples: Precision Camshafts and Power Mech Projects.

On the whole, investments meant for long-term are generally beneficial. It is better to equip oneself about the details of the company. Long term investors stay calm in turbulent times wait for the tables to turn. On the other hand, short term gainers should opt for selling shares as and when profits are available.

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