Monday, December 31, 2012

Things to check before subscribing to an IPO

After almost a year of silence, the Primary Market in India has started reviving itself. In the past few months, we have had a few IPO's hit the Market and there are many more that have applied permission from SEBI to go public and issue Equity Shares. With the Stock Market being volatile as well as attractive at the same time, Investors have to be doubly careful while subscribing to IPO's. There was an article that I wrote last month titled List of 87 Companies that have Vanished after raising funds through IPO in India which listed the companies that vanished after their respective IPO's thereby causing significant losses to innocent investors. So, as smart investors, it is our duty or should I say responsibility to thoroughly research the IPO offer and invest only if we are satisfied. Though a detailed technical analysis is out of scope for common layman investors like you and me, there are a few simple tips and tricks that can help us identify the Good Issue and more importantly spot those potential disasters.

Before we begin:

There have been multiple articles in this blog covering the topic if IPO. You can revisit them to brush up your memory if you can’t fully understand the lingo used in this article...

1. Equity Shares
2. IPO Process Explained
3. IPO - Different Types of Issues
4. Intermediaries involved in an IPO Process
5. Different Categories of Investors for an IPO

Now that we have brushed up our memory, let us look at the key factors we must consider before deciding to subscribe for an IPO issue and their respective Weightage in our decision...

Factor 1: Check the Lead Managers and their Credibility - Weightage 10%

The first and foremost thing to check while analyzing an IPO is the credibility and reputation of the Lead Managers of the issue. Remember that the lead managers’ credibility could act only as an indicator to the proposed issue, but does not assure success. There have been poor issues in the recent past from good merchant bankers as well.

Though a good lead manager does not guarantee success, a not so reputable lead manager should raise the Red Flag.

Factor 2: Check the Promoter Holding in the Company - Weightage 10%

Promoter Holding refers to the amount of shares (In %) that the owners of the company will retain. In cases where promoters hold a significant share, say like 70% or 80%, the stock may not be liquid enough. If there are fewer shareholders in the market, it will eventually result in fewer shares available in the Market.

Another aspect to check here is the amount of Preferential Shares that the company has issued till date. If there is a significant % of preferential shareholders, the value of the common stock that you or I will be buying via the IPO is going to be lower.

Check for interest from financial firms or venture capital firms in the organization. If large financial institutions have confidence in the company and have invested huge amounts in it, the chances are that the promoters have a good background and history of profit making.

Factor 3: Check the plans for how the company plans on investing the money gathered via the IPO - Weightage 20%

Most companies go public to raise funds which they intend on utilizing for some purpose. The company has to explain how it plans on using the money in the prospectus. If the company intends on spending the money wisely, then it would obviously be a good idea to invest in it. But, if they are mobilizing funds to let’s say "Invest in Land" or "Construct Buildings" etc., we must be cautious. Remember the Satyam Fiasco? The Chairman of the erstwhile top IT Company had bought land worth thousands of crores while fudging his record books thereby swindling off investor money...

If the company is going to utilize a portion of issue proceeds towards paying off high-cost debts, it would benefit the company in terms of lower interest outflow and therefore higher profitability. Similarly, if they intend on starting out new ventures using the money, it could have a positive effect on the profits as well.

Factor 4: Check the Company's Sector and the Growth Prospects for the Sector - Weightage 10%

A Great company in a badly performing sector cannot give as much returns as it would if the Industry Sector as a whole was performing well. For Ex: The Telecom space in India is under severe stress. Heavy competition, extremely competitive pricing, multi-million-dollar scams and penalties etc. have ripped the Telecom space into shreds. In spite of being extremely profitable, the giants like Airtel and Idea Cellular are still struggling in terms of stock price movement.

Another aspect to look along the same line is the global vs. local demand. If a product has significant demand both locally as well as globally, a slowdown in either the global or local market won’t have as much impact as it would if the company had 90% revenues from either market.

Even the recently completed Bharti Infratel IPO wasn’t fully subscribed from the Retail Investor population. People felt that the Telecom sector as a whole is in trouble and opted to be cautious while subscribing to the IPO. If I were analyzing Bharti Infratel under this factor, I would probably give it a 5 or a max 6 out of the possible 10.

Factor 5: Check the Promoters Experience and History of Profit Making - Weightage 25%

This is probably the second most significant factor to consider while subscribing for an IPO. That is why I have given it a 25% weightage.

No matter how big or small a company is and no matter how much or how little funds they mobilize via IPO, if the Promoters don’t do their jobs properly, there is a 100% guarantee that the money we invested in the company is gonna go down the drain.

Some questions you should ask yourselves are:

1. Do the promoters have previous experience in transforming organizations from the grass root level in the same industry to a successful business?
2. What is the experience they have in the sector the company is operating in or any other sector?
3. What is their profit making history? Have they made profits at least 75-80% of the time in the past?
4. Did the company meet its sales growth targets projected?
5. Is the company growing at the same pace or at a better pace when compared to its peers in the same sector?
6. Is the company making the same profits or better profits when compared to its peers in the same sector?

You can also check out the profitability of any subsidiary or affiliate company in which promoters have a stake. This would help us to ascertain the management’s efficiency in terms of managing multiple organizations. Remember to check for litigations against the promoters, nature of litigation and the promoter’s extent of liability, if any. If there is a multi-million-dollar lawsuit against a company for some reason and they are coming up with an IPO, do you think anybody will subscribe to their IPO?

Factor 6: Is the Issue Price Justified? - Weightage 25%

This is the most important factor while considering an IPO issue. This factor again has a 25% weightage. Every company has a certain value that reflects in its Stock. If investors feel that the price of a share is lower than its value, people buy and if they feel a stock is overpriced, they sell. I don’t intend on getting into the specifics here, but remember this, if the shares of company X is trading at Rs. 100/- per share in the market currently and company Y that is almost similar to X is coming up with an IPO where its shares are priced at Rs. 200/- per share, what would you do?

I would ask myself the question, what is so special about Y that it demands such high valuations?

How to go about analyzing this Factor?

Remember an article titled "Market Ratios" that I had written 2 years ago? It lists down all the various ratios that you can compare for this factor. Search Google or any site like You should be able to find out the numbers for all the companies that are peers to the company coming up with the IPO and are already listed in the stock market. Open up the prospectus of the IPO and gather those numbers for this issue. See if they are comparable.

Again, going back to the Bharti Infratel IPO, the P/E Ratio based on the offer price and the past 1 year's Earnings per Share was 49 while the P/E for other established and listed Telecom majors were much lower. Bharti Airtel and Idea Cellular were trading at around 35 times P/E while Reliance communications was trading at only 19 times P/E. This was one of the reasons why retail investors decided to wait and watch for this issue rather than rush in to subscribe.

Important Financial Aspects to check:

1. Price to Earnings Ratio - P/E
2. Earnings per share - EPS
3. Operating Margin
4. Market Capitalization

If you compare the new issue with that of an existing stock, the numbers must be comparable and the difference must be in favor of the new issue and not the already listed stock.

How to arrive at the final decision?

Take out a notepad and a calculator. Create a table like below:

FactorScoreWeightageWeighted Score
Lead Manager Credibility10
Promoter Holding10
Plans for Investment20
Company Sector10
Profit Making History25

After you gather information about each of the 6 factors above, assign a rating score of 1 to 10 with 1 being lowest and 10 being highest. Let us say, based on what you learnt about the company promoters history of profit making and operation, you feel they have a great chance of making profits in future as well you may assign them a 8 out of 10. If you feel they have a good chance but aren’t sure if their chances are great, you can assign them a 6 out of 10. If you are totally unsure of their future profit prospects, you can give them a 2 or 3 out of 10.

This way, assign a score for each of the factors. Let us say I am analyzing the IPO of Kekhran Mekhran and Company that is due to open in January 2013. So, I am assigning the following values:

FactorScoreWeightageWeighted Score
Lead Manager Credibility910
Promoter Holding610
Plans for Investment620
Company Sector710
Profit Making History525

After you enter your score from 1 to 10 for the 6 factors, multiply the score with the Weightage and calculate the Weighted Score. Once we do that, the table will look as below:

FactorScoreWeightageWeighted Score
Lead Manager Credibility91090
Promoter Holding61060
Plans for Investment620120
Company Sector71070
Profit Making History525125

Sum up the Weighted scores in the last column. In this case my total comes to 565 out of 1000.

How to Understand the Weighted Score:

Below is how you must understand your weighted score. Though the investment decision is entirely yours, I have mentioned an upper limit to the amount of money you should invest for each category because it is always a good idea to limit our exposure to IPO issues. No matter how high or low the weighted score is, we never know how the stock will perform once it gets listed. So, we must be careful. Here, the term "Portfolio Net Worth" means the total value of your Investment Portfolio. Remember what an Investment Portfolio is? If not, Click Here to find out.

So, if my total Portfolio is worth 5 lakhs, I will not invest more than 50,000 rupees in an issue where my weighted score works out to more than 800 or I will not invest more than 40,000 rupees in an issue where the score is between 700 to 800 and so on...

Weighted ScoreInvestment ChoiceWhat to Do
800 or AboveAn Excellent InvestmentYou can consider investing in the IPO with prospects of great returns in the future. Remember to limit the exposure to less than 10% of your total portfolio Net Worth
700 to 800A Good InvestmentThe IPO has a good chance of being a profitable investment. So, if you decide to invest in this issue, limit the exposure to 6-8% of your total portfolio Net Worth
600 to 700A Decent InvestmentThe IPO has a decent chance of being a profitable investment. So, if you decide to invest in this issue, limit the exposure to 5% of your total portfolio Net Worth
500 to 600A Medium Risk InvestmentThe IPO has a 50-50 chance of profit/loss. So, if you decide to invest in this issue, limit your exposure to less than 5% of your total portfolio Net Worth
400 to 500A High Risk InvestmentThe IPO is a high risk proposition. There is a more than 50% chance that your investment will end up in losses. So, if you decide to invest in the issue, limit your exposure to less than 3% of your total portfolio Net Worth
Less than 400don’t even think about itThe IPO is an extremely high risk proposition. If you invest in this issue, only God can Save you…

Some Last Words:

As with any stock market investment, the chances of Losses are very real. As this is the first time the stock of this company is going to get listed, the chances of losses are even higher. More importantly, NO technique of Stock Analysis is fool proof. This is just layman’s way of analyzing an Issue. A lot more analysis is done by Brokerage Houses and Investment Advisors before advising their clients as to whether they must invest in or avoid the IPO. As I always say, believing blindly in advisors recommendation is a bad idea. So, if you read a report suggesting you either invest or avoid an issue, you can spend some time, do the calculations yourselves and corroborate the decision...

At the end of the day, the decision as to whether to invest in the issue or avoid it is entirely yours. So, take a wise decision!!!

Happy Investing!!!

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