IPO – Factors I Consider before Investing in an IPO

Investing in IPO is more like a lottery these days. Good IPOs are so overly subscribed that you seldom get any allocation. Bad IPO are not that well subscribed, and so you have higher chances of allocation, but often they aren’t worth investing in.

However, as an investor, if you find a great company to invest in IPO, there is no harm in even buying it on a listing day.

DMart or Avenue Supermarts is one such example where the IPO was priced at ₹300, and it listed on the exchanges at ₹600. As a result, those who invested on a listing day have made six times their invested amount in 4 years, from April 2017 to June 2021.

So investing in an IPO can be beneficial if you aren’t focusing only on the listing gains. Instead, one should analyse the business and remain invested in great companies for the long term.

So here are factors to consider when investing in an IPO.

The Reason for an IPO

The first and the most important criteria for an investor to consider investing in an IPO should be understanding why the company is coming up with an IPO.

The definition of IPO is – When a company wants to allow investors to be its partners and shareholders. The public offering of a privately held company to list on the exchanges is known as Initial Public Offering or IPO.

In other words, the promoters or and existing investors in the company wants to sell their stake.

So, as an investor, you should always be cautious about why the existing shareholders (including promoters) want to sell.

Ideally, the best company to invest in is the one that has aggressive plans to expand and grow with the money that they will be getting with the IPO.

A great example is DMart. They established a great business model in a couple of states of India. The reason for an IPO was to get PAN India presence in a few years.

Similarly, Burger King has a great business model, and now they want to open stores in PAN India aggressively.

Can you Understand the Business?

The next important factor to consider while investing in an IPO is to be able to understand the business. Furthermore, one should consider the growth outlook of the company align with your worldview.

IPO is the time when everything is overhyped.

There are only two views when investing in an IPO.

1. Listing Gains
2. Price (Current financial performance make it either costly or cheap)

I rarely see any news channel expert have any views related to the company’s actual business that has an upcoming IPO.

However, if you want to consider investing in IPO, you should try to understand the underlying business rather than understand the financials.

IPO is a stage where the company is willing to grow faster, and so past years will have a lot of experiments about the business, which can impact financials in many ways.

If you can understand the business, you should consider IPO for investing but not otherwise.

Cash for Growth or Paying off Debt

Going public for the company means there will be a massive infusion of capital in the company. Make sure you understand how the company is going to use the fund for growth.

What is the company going to do with the cash is an essential aspect of investing in an IPO?

• What part of the money coming into the company will be used to reduce debt?
• Is the cash for future growth?
• How much will the promoters use personally, or will any existing promoter/shareholder exit?

When you can understand the cash flow of the company and its plans, investing in an IPO becomes that much easier.

Market Leadership

Is the underlying business a market leader in the segment it operates?

Once you invest in a company that is a market leader, you are sure to see good growth in the post-IPO years.

Page Industries, now we know, has given 100x returns since its listing a decade ago. Of course, the main reason for such great returns is because it was a market leader in the segment it was operating then. But, slowly but surely, it has transformed itself to be the market leader in a vast segment.

When you invest in a company that has already attain market leadership in a small segment, it means you eradicate the risk of no market for the business.

There is much business that goes public but isn’t able to grow. The main reason is when the company tries to grow, but the market leader doesn’t allow such a high growth rate.

So, either the business either has to opt for slow growth or compromise on the operating profit margin. In either case, the share price doesn’t appreciate to the extent investors want it to.

Lovable Lingerie is one such example. After 5+ years of an IPO listing, there is hardly any returns for the investor. They are not the market leader in the Readymade Apparels, and it is tough to beat Page Industries.

The Valuation

The last and final factor one should consider when investing in an IPO is the valuation.

Big companies like the Tata’s and Ambani’s bring credibility to the IPO but add a lot of premium to the price.

The sad part is that they tend to bring in the IPO at a nascent stage of the business and not in the growth phase.

So one should always consider the price at which an IPO is available.

Great promoters will offer a great value at the price because they know the future aspect of the business will increase the price of the company. So they aren’t coming up with a public offer to make quick money but want to make money doing the business.

However, some businesses want to get the maximum valuation out of the IPO itself.

Apply as Retail Investor

As a retail investor, we can invest up to a maximum of the worth of Rs 2 lakh in an IPO. However, you can invest more via the HNI or High Networth Individuals.

Still, I think it is better to apply for an IPO as a retail investor and add more on the listing days.

The reason I say this is because the guidelines of SEBI are designed to maximise retail investors allocation. The retail quota is at 35% in a book-built IPO. So it increases the probability of shares allocation.

Final Thoughts

Allotment in an IPO depends on many factors, and it seems more like a lottery. The approach that works better is to make multiple applications.

As a retail investor, one can make a maximum of five applications. In case of oversubscription, make more applications with minimum lot size to increase the chances of allocation.