Equity Investing: Six important steps to choosing an IPO

Finding an excellent IPO to invest in is not impossible, but it is undoubtedly a difficult task requiring detailed and extensive research.

By A P Singh

Many companies are coming up with their Initial Public Offerings (IPO) these days, but you should be cautious while selecting the right IPO for your investments. Investors may think investing in IPOs could give them significant gains on the listing, but that is not always true. There were IPOs in the past where investors had suffered losses on the day of listing or afterward. Finding an excellent IPO to invest in is not impossible, but it is undoubtedly a difficult task requiring detailed and extensive research.

A profitable IPO comes with specific characteristics that need to be understood by the investors. Before investing your money in an IPO, looking at the company’s credentials is essential. Besides checking the company’s finances (at least three years), prospective investors must also look at other indicators for identifying the IPO for their investments. Let us understand six factors that should be considered before investing in an IPO.

DRHP – An investor’s Bible

One of the most important repositories of the company is the ‘Draft Red Herring Prospectus (DRHP)’. Companies must file their DRHP with the Securities Exchange Board of India (Sebi) while floating an IPO. Analyzing this document would give you financial and other information about the company, like the quality of management, history of work experience, qualifications and projects handled, etc. It will help you identify the risks and opportunities involved with the firm.

Subscription by QIB

Another way of selecting an IPO for investment is to look for the subscription in its qualified institutional buyers (QIB) category, as that gives an idea of the quality and pricing of the issue. These institutional buyers have better access to data that individual investors may not have. After extensive research, they invest in IPOs and will not invest in an IPO, likely to generate negative returns. A shallow subscription level would mean institutional investors do not see the issue as a strong proposition and such issues should be avoided. If the QIB category is oversubscribed, then you can proceed. A very high level of oversubscription would also mean substantial retail subscriptions and fewer chances of allotment, which may make the entire exercise futile.

Take a look at the valuation.

This may seem tricky for retail investors, but it is an important aspect that shouldn’t be overlooked. Ratios like price-to-earnings and price-to-book-value should be considered and compared with their peers for the correct valuation. If the price is overpriced compared to the shares of peer companies, then the investment should not be made.

Company’s financial performance

One should also check the company’s financial performance year after year. If the company’s revenue and profits are growing, the firm is growing well and has growth potential. However, if the company’s performance is lower than the industry, it is likely an underperformer. This is when you should look for better investment options.

Understand risk, the prospect

You can select companies with excellent and innovative business models that can sustain you in the future. Understanding the risks associated with each business is an essential step before investing. The current market environment, number of competitors, and product or service quality will all play a crucial role. The company’s prospects should also be checked if you are investing for the long term through IPOs.

Understand the business

Generally, avoid investing in a business you don’t understand. You should invest within the circle of your competence. This is because a thorough understanding of a business can help you make better decisions. It is always better to do your homework instead of relying on mere hearsay, tips, or rumors in the market.

The writer is the director of the Amity School of Insurance, Banking & Actuarial Science, Amity University.