Clearing the confusion from IPOs to make sound investment decisions

Category : Knowledge Center

India has a rich history of entrepreneurial achievement. Many indigenous businesses began as small shops and have grown into multibillion-dollar conglomerates. With a single person or a handful of individuals owning a company, it is always a struggle for the company to raise capital beyond a certain point. With the kind of ambitious plans companies have, they need bigger investments that go beyond your typical bank loans, etc. So they venture out to look for new partners to invest capital in their ambitions. Venture capital funds help in this transition, as their main job is to identify good, strong companies and buy stakes or shares in them for a large sum of money so that the company can grow further even if it dilutes its share. Once the venture capital funding is exhausted and the company has reached a certain size, its next objective is to again find that catalyst that can catapult it into the big league. That would mean rapid expansion of operations or starting new lines of business in allied fields. This is when the company goes out to the public to raise money. People can buy part ownership of the company for as little as 10 rupees. Therefore, if the company has Rs. 5 crore invested in it and you have invested 10 rupees in it, you own the proportionate share of the company (i.e., 2e-7%). This process of going public is called an initial public offering, or IPO.

 Follow-on Public Offering:

A company dilutes its shares conservatively. Only that much of the share is diluted as is absolutely necessary to raise capital during the IPO. But as the company’s plans go along, a situation can arise where it requires more capital and is confident enough in its standing in the market to be able to do so by issuing more shares. This is called the follow-on public offering, or FPO. A FPO issued by a reputable company is an appealing avenue to invest in because the company will have a proven track record and documentation to demonstrate its financial performance over a long period of time. It also often leads to smaller investors getting a chance to invest in a company that has been hitherto unaffordable for them.

Is Investing in IPO Advisable?

How do you buy your soap or shampoo? You look at the advertisement and know that some of it might be true and some might be exaggerated. You take a chance and see how it goes. If it doesn’t, you switch to another next time. and so on. Now with an IPO too, you have no history of the product. The company is listing for the first time, so you don’t have much knowledge about its past. All you have now is its "red herring" prospectus, which in itself is the advertisement for the said IPO. So you have to take the prospectus with a pinch of salt. Add to that the complexity of price fluctuations the moment the stock is listed on the market and the inherent difference in the price of a stock versus an equity share.

Investing in an IPO means you are investing in the company’s founders, their performance thus far, and their vision for the future. The information will be limited, but it’s important to research all of these through whatever sources are available before investing.

Also important is to see which brokerage house is underwriting the IPO. Big brokerage houses are usually a better bet, as they won’t touch a less-than-ideal company.

There is also the hype and sentiment in the market that can influence your decision. A consumer-facing, attractive brand can garner a lot more positive or negative discussion than, say, an industrial company. It is important to separate this hype from the facts.

Technically, there are two other aspects to be cognizant of while investing in an IPO. The first is day trading. A lot of the investors in an IPO are day traders who are just looking to buy cheap and sell high within a couple of days. They are not invested in the performance or future of the company. This raises share prices on the first day and then drops them the next day. In such a case, buying the shares at what you believe is a fair price and resisting higher prices is critical.

The second aspect is that of the lock-in period. People associated with the company are issued shares with a lock-in period around the IPO. During this period, they cannot trade their shares on the market. Once this lock-in period lapses, in 3 to 24 months, there is a sudden rush to sell these shares, and the market gets flooded with extra supply, bringing down the prices.

Invest in an IPO when you have better confidence in your knowledge of the industry, the founders, the company, or relevant government policies. But always invest in the future of the company. Don’t look to just take a gamble and make a quick buck.