The Indian stock market has grown steadily in the past couple of decades and since the pandemic the number of retail investors has grown exponentially. This can be attributed to a few factors like the explosion of smartphone and internet connection, improved financial literacy, and most importantly more money in hand to invest.

As an investor, you must always evaluate your risk tolerance and the capacity to invest money in the stock market as it involves various types of risks. If you plan to invest in good quality stocks, there are two ways in which you can do it. One is the Initial Public Offering which has become a favourite among retail investors and the other is through the secondary market. Each of these ways has their own pros and cons and you must take a well-informed decision before you invest your capital. In this article, we are going to look at the important things you must consider before investing in an IPO.

Let’s Understand IPOs

A company going public is an important event in its journey to becoming a market leader. Initial Public Offering is the process of selling a company’s shares to the public on the exchange and by doing so, a privately held company becomes a public company. So, when an investor buys shares of a company, he/she owns a part of the company and becomes a shareholder of the company.

Why Companies go for an IPO?

Companies go for an IPO for a lot of reasons but primarily for raising capital from the public who are retail investors, high net worth individuals, domestic institutional investors and foreign institutional investors.

The capital raised from the public can be used for business expansion that includes funding new projects, increasing production capacity, building new plants or factories, entering new markets, marketing, etc.
Companies also spend the fresh capital for research and development purposes that involve investing in innovation or developing new products. A company can also use the money to pay off debt that is expected to improve its balance sheet and financial health or use the funds as working capital for day-to-day operations.

An IPO is also a path for early investors like founders, venture capitalists, private equity companies or angel investors to divest a part of their shares or the entire shares to the public to make profits on their initial investments in the company.

What to evaluate before you invest in an IPO?

With India being the fastest growing economy in the world, many companies are looking at IPOs to fund their growth plans. But as an investor, you must be cautious in picking the right companies that are financially sound and have good growth opportunities in the sector they are operating. In this section, we are going to discuss some of the important factors to check before investing in an IPO.

You must clearly understand the company’s business model, the products or services it is offering, how it makes money, its target customers, etc.

The company must be operating in one of the sunrise sectors, for example green energy, AI, electric vehicles, etc. or in a sector where there is a lot of scope for growth.

The company must have moat or competitive advantage so that it is very difficult for other companies to replace them. A company with good competitive advantage will have a higher market share and it will have pricing power.

The company must have a strong balance sheet for the past 3 to 5 years and it must have grown consistently with respect to revenue and net income. You should also check some of the important financial metrics like RoCE, ROE, ROA, which are important to evaluate their valuation and efficiency. The company must have low debt levels and positive free cash flow.

An investor must also take a look at the valuation metrics like Price-to-Earnings (P/E) ratio or Price-to-Book (P/B) ratio and compare it with its peers. If the price is significantly higher than its peers, then there must be strong reasons like faster growth, higher margins, etc. to justify the higher price. Otherwise, the IPO is overvalued.

Investors must be cautious about the company’s corporate governance, reputation of the founders and management team. Promoters must always have high stakes in the company and any signs of promoters diluting their stake substantially in the company is a red flag.

Investors must thoroughly study the red herring prospectus and understand the strengths, weakness, opportunities, threats and risk factor involved in the business.

You must also check the reputation and history of underwriters and investment banks that are involved in the IPO as they bring trustworthiness and credibility. In addition, the overall market sentiments must be assessed because many IPOs usually come to the market when there is overall optimism in the economy and as an investor you must not be carried away by this optimism.

Conclusion

A company coming out with an IPO is always exciting for investors as they try to find the next multi-bagger, but the decision to invest must be backed by thorough research and critical analysis and not by emotions or FOMO. IPOs can be a double-edged sword because the price can move in any direction post listing, so it is better to look at it from a long-term perspective rather than a one-time lottery.

Frequently Asked Questions (FAQs) on IPO Investing

1. What is the important document I must check before I invest in an IPO?

The most important document any investor must check before investing in an IPO is Draft Red Herring Prospectus or Red Herring Prospectus. A retail investor can find this document in the SEBI website as it is mandatory for the company to file it with the market regulator. The link is here

2. What is the fundamental difference between buying a stock in an IPO and buying it in the secondary market?

The fundamental difference is the source because when you are buying a stock through an IPO (primary market), you are buying shares directly from the company or early investors of the company as it is going public for the first time. Buying shares in the secondary market i.e. post listing on the exchange is buying shares from another investor who already owned the company’s shares.

3. Why do companies want to go public?

Companies primarily go public to raise money from a wide pool of public investors that includes retail investors, HNIs, domestic and foreign institutional investors, etc.). This capital is used for funding their business expansion, investment in R&D, building new plants, buying equipment or paying off existing debt to improve their financial health. Going public also helps the company in improving their brand and trustworthiness.

4. What are the important financial metrics investors should check before investing in an IPO?

Investors must look at the company’s strong and consistent growth in revenue and net income over the past 3 to 5 years. Important financial metrics include RoCE, ROE, and ROA (Return on Capital Employed, Equity, and Assets) to evaluate efficiency. Companies having low debt levels and positive free cash flow are also crucial to sustain their business and thrive among its competitors.

5. What are considered “red flags” in a company?

A major red flag in a company is any sign of poor corporate governance or a questionable reputation of the founders and management. Investors should be really cautious if the promoters or founders are substantially diluting their stake in the company, as this can signal a lack of long-term confidence in their own company and its future growth.