What to consider before investing in an IPO?

There is a lot of buzz in the primary market after remaining muted for the most of the year 2020.  Many private companies have decided to go public by making its shares available to investors in the stock market. This process is popularly known as Initial Public Offer (IPO)

Selecting an IPO for an investment purpose is not an easy task. Therefore, 5 paisa team has come up with the points to look for before selecting an IPO. An investor must understand the basics and financials of the company before applying for an IPO. The information about the company is available in draft red herring prospectus (DRHP). In simple words, a DRHP or offer document provides detailed information about the business operations and financials of the company. The Securities and Exchange Board of India (SEBI), has made it mandatory for companies to file a DRHP before going for an IPO. 

However, going through a huge document may be a tedious task. So, investors can focus only on some of the essential parts of the document, which will be good enough to understand the business and its prospects.

Below, are the key points one must look at the DRHP and in general before applying for an IPO

Management Team and Promoters Background:
Promoters and top management are the key assets of the company. Take a close look at promotes and managers who are usually going to take all the decisions of the business. The investors should check on experience, salary paid and the average number of years spent by the top management in the company. They should also check, there is no corporate governance issue in the company because any negative news could be a red flag and adversely affect the future performance of the company.

Strength and Financial Performance of the Company:
The investor should also take note of the company’s strength and its positioning in the industry. Studying about the positioning and strategies will help to visualise the future prospects of the company. Similarly, going through the historical financial numbers is also important. It is essential to check if there is a sudden spike or fall in financial performance in the past one year or few quarters just before an IPO.

Understand the objective of the issue and shareholding of the promoters:
It is important to check the promoter shareholding before and after the IPO. A higher promoter shareholding in the company is always better for minority shareholders. It is also important to understand the utilization of funds raised through the IPO. If the funds will be utilized in the existing business or for an expansion, it will be a good sign of future prosperity.

Check the Valuations:
This seems tricky for retail investors but it is an important aspect that shouldn’t be ignored. To begin with, see how the valuation of the company fares as compared to existing companies in the same industry. Relative valuation techniques like Price to earnings ratio, price to book ratio and return on equity, return on capital employed can be used to conclude whether the IPO is available at a discounted price or is expensive as compared to its competitor in the market.

Read the Research Notes and Risk associated with the business
The retail investor should consider the views provided by various brokerages in their IPO research notes, which are publicly available. 
Secondly, companies need to mention all major risk factors related to the business in its prospectus. Reading the risk factors is very important. At times there are certain litigations and liabilities, which can be a threat to the company’s future business prospects.

Conclusion:
The decision to go for an IPO must depend on your investment objectives, how much risk are you willing to take, and whether you believe in the growth potential of the company. Don’t make decisions based on the publicity or peer pressure or recommendations. Be wise and take informed decisions. Good IPOs can give magnificent returns in the long-run.