Initial Public Offering

What is an IPO? And Should You Invest in Them?

March 27, 2018 0 Ankit Shrivastav

Initial Public Offering:

IPOs or Initial Public offering have been the buzzword in the current market. With a string of big IPOs such as HAL(Hindustan Aeronautics Limited), ICICI Securities, ready to be listed soon, it is important to understand what an IPO is, How it works and whether you should invest in them or not. This post is not a an IPO review but a general take on awareness about IPOs.

Initial Public Offering

What is an IPO?

When a company wants to expand its business, it needs money to fund it expansion. An Easy source of capital is borrowing funds from bank at an interest. However, borrowing from bank has two major disadvantage.

First, capital borrowed from banks is bears an interest, which has to be paid on a monthly basis irrespective of whether the company is making a profit or not. Secondly, If a company requires really huge capital, lending such a huge capital to a single entity exposes banks lending portfolio to a huge risk, which a bank may not be willing to take.

To solve this problem, IPOs were introduced, where a company can give away a part of ownership (that is a Share) in business to general public in exchange for money.

The advantage of this system is that companies can raise capital, (especially large sums) without any obligation to pay regular interest, and investors of IPO(that is general public) get capital appreciation(appreciation in share price) at a higher rate than offered by a fixed income instrument.

Secondly, investors are also rewarded by frequent dividend payouts. A dividend is a part of companys annual profit that it decides to share with its shareholders. Dividends are given on the face value of the share(which is usually Rs. 10 per share) and are distributed to shareholders on a per share basis.

For example, if a company has decided to give 100% dividend to its shareholders, it means, the company will distribute Rs.10 per share to each shareholder. So if you have 100 shares of the company, you will get Rs.1,000 as dividend (10*100=1,000).

Since we have understood the IPOs let us now understand the mechanism behind IPOs, and how they are issued:

Initial Public Offering

How IPOs are issued?

A company cannot simply go and issue its shares in the stock market and raise money, there is a formal process behind raising capital by issuing IPO for which a company has to hire an investment bank, which goes through the process of underwriting.

Initial Public Offering

Step 1: Hiring an Investment Bank

As mentioned earlier, Initial Public Offering or an IPO is basically issuance of part ownership in the business of the company to institutional investors and general public. That is why, it is important to understand the current valuation and future growth potential of the business. For his purpose, companies willing to issue an IPO hire an investment bank. An investment bank is an institutional entity that acts as a financial intermediary.

It is responsible for evaluating the current business value, which includes quality of management, past financial record, current status of business, and future growth potential of the company such as growth in the sector, market share of the company future expansion plans etc.

Companies looking to go public, must meet some of the milestones set by the market regulators after which the company may discuss the amount of money it is willing to raise, type of securities to be issued, after which, the process of underwriting may begin.

Initial Public Offering

Step 2: Entering an Underwriting Agreement

This is the second step in issuing Initial Public Offering. Once the amount of money to be raised is finalized, the process of underwriting begins. Underwriting is the process in which investment banks raise capital from investors in the market on behalf of companies and in case they fail to raise the targeted amount, it is the duty of an underwriter to buy the remaining shares. This makes a job of an underwriter very risky.

This is why, Underwriters, before entering the agreement, weigh the company and its growth potential to arrive at a fair valuation of the company. This helps them in understanding the true market value and the amount of risk involved in underwriting the security.

Once the analysis is done ,the underwriters enter an agreement with the issuing company, agreeing to act as market maker, raise the capital needed and buy its shares, in case it is not able to raise the amount of capital required.

Once the underwriter enters the agreement, Documents containing details of IPO are sent to market regulator(SEBI) for approval. The documents is called registration statement.

Initial Public Offering

Step 3: Filing a Registration Statement:

The registration statement consists of information regarding Initial Public Offering, the financial statements of the company, the background of the management, insider holdings, any legal problems faced by the company, and the ticker symbol to be used by the issuing company once listed on the stock exchange.

The market regulator ensures that all the information disclosed in the documents filed are correct after which the effective date is decided where the underwriter decides the offer price or the price band(in case of book built issue) and the number of shares that have to be sold.

Deciding the price band is crucial as it is the price at which the issuing company will raise capital for itself.

Once the process is done, the underwriter prepares an offer document which contains the offer price at which the shares can be subscribed and allotted. There are two ways in which the price and allotment of an issue can be determined:

Initial Public Offering

Fixed Price Issue:

The company in consultation with the investment banker would decide the price at which the shares will be issued. The price, as the name suggest remains fixed till the date of listing and investors willing to invest in the company have to subscribe to the issue at the price mentioned. The issuing company has to justify the price based on the past performance and future growth potential.

Book built Issue:

This is more commonly used method of allocating shares these days. The objective of book built issue is to identify the price that market is willing to pay for the shares being issued by the company. In other words, book building method uses bidding approach to understand the markets view about the issuing company.

The issuing company and the underwriter determine the floor and the price band within which investors can bid. When the issue opens, investors willing to invest put their bids specifying the price and the number of shares they are willing to buy. The price bid should be above the floor price and within the price band applicable.

The issuer, in consultation with the underwriter and lead manager decides the cutoff price which is the price at which, the issue gets subscribed. All investors who invest above the cutoff price are allotted shares. For those who bid below the cut off price, refund is made to them in their bank account. Once the allocation is made to each investor, the shares are then listed and traded in the stock exchange.

Should you invest in IPOs?

The answer to this question is not simple and straightforward. Before we reach a conclusion, we must analyze both advantages and disadvantages of investing in IPO. So here are the advantages and disadvantages of investing in IPO(Initial Public Offering)

Initial Public Offering

Advantages of investing in IPO:

There are many advantages of investing in IPO, some of them are listed below:

Catch before they hatch:

Most of the companies that issue IPO are small or medium in size,since most of these companies are in their early stages of business life cycle, by investing in such businesses you catch the worm early. Since such companies have great growth potential, an investor can benefit immensely from them in the long term. Many IPOs that were issued a decade ago have made tenfold returns, making investors rich and happy.

Low chances of Price Manipulation:

Most large investors use pump and dump technique to manipulate market price to gain unfair advantage over retail investors. Since shares issued during IPOs are issued for the first time, there is a slim chance of prices being manipulated.

Some IPOs give a discount:

Some IPOs also provide shares at a discount to retail investors upto 10% of the price. This gives retail investors a head start over institutional investors, something which is not available in the secondary market.

Initial Public Offering

Disadvantages of investing in IPOs:

While it may seem like IPOs are great for investment, there are some disadvantages of investing in IPOs too:

Limited Information about company history:

Since companies list their shares for the first time via IPOs, there is a limited information about the company. All the information available is via their prospectus and offer document, which usually presents a rosy picture of the company and its management. Thus it makes it difficult to make decision in the absence of sufficient information about the company.

Allocation of shares is difficult:

Even if you manage to find sufficient information to make an informed decision, getting sufficient number of shares allocated to make a meaningful profit is difficult. Most of the IPOs get oversubscribed, meaning the number of applicants surpass the number of shares available to be allocated. In such a case, each applicant get lesser number of shares as compared to what he had applied for, making it difficult to make significant gains, even of the IPO performs well.

Conflict of interest:

There is always a conflict of interest between company and investors while issuing IPO. An investor makes money when he buys a great business at a low price. On the other hand, the company issuing the IPO wants to maximize capital raised by issuing the IPO, which is possible only if the IPO is subscribed at the highest value. Clearly, both investors and company are on the opposite sides, No wonder why most IPOs(especially big ones) are usually issued when markets are bullish, as investor sentiment is very positive and people are ready to pay higher price for everything.

As an intelligent investor you must always weigh the price against the value of the company by assessing the total business value of the company, its growth potential, and its present intrinsic value.

So, Should you subscribe to IPOs?

The answer to this question is very subjective, and depends on many factors such as:

Initial Public Offering

Quality of management:

The quality of the management can be assessed by looking at the management of the company such as who are the key personnel? How long have they been associated with the company and how has the company performed since then. All these questions are vital to assess the corporate governance and quality of the management of the company.

Past financial performance:

You can find this information easily in the offer documents of the company which you can get online. Past financial performance give you a clear idea about how profitable a company has been in the recent past. Go through their sales, Net profit, debt levels.The document also mentions reasons why they are issuing the IPO and where the proceeds of an IPO will be used.

Comparing listed peers:

You can also compare the comparing the financial performance and other factors with already listed peers working in the same sector. By comparing peers, you will be able to assess the attractiveness of the IPO compared to other companies. If the IPO seems to be expensive or financially under-performing compared to listed peers, it would be better to buy shares of listed peers instead of subscribing for new IPO.

conclusion

Conclusion:

IPOs can be very profitable investments, provided you have done your homework properly before making an investment decision. You don’t have to subscribe to an IPO as not all the IPOs are not going to be successful you may end up losing most or all of your money.

Before making any subscription, please make sure that you know enough about the company, it’s management, financial performance and future growth potential, and compare it to its peers to understand the market position of the company and if it is worth putting your hard money.

If you have subscribed or are subscribing to any of the IPOs, do let us know your views in the comment section about it, if you have any queries, you can mail us at info@infimoney.com