Too many IPOs? How to separate quality from hype during a listing frenzy

Read the RHP, compare valuations and do not chase grey market premiums or listing gains. Investors should check whether the fundraise is for business purposes or for existing shareholders.

In July, gross issuances in the primary market topped ₹20,100 crore. That milestone is likely to be surpassed in September, according to a report in Business Standard. About 20–25 companies are likely to launch their initial public offerings (IPOs) this month. Investors should do their homework amid the rush.

 

Start with business quality

 

Understand the business before applying and use the same business-quality checks you would use for a mature company.

 

“Review management commentary on expected performance over the next couple of quarters rather than relying on forecasts too far into the future,” says Ankur Kapur, investment advisor, Plutus Capital.

 

Study the company’s competitive advantage and go for one that will be able to maintain it for a considerable period.

 

Study the financials

 

Besides revenue, study margins. “Check whether revenue growth is backed by improving margins rather than by discounting,” says Trivesh D, chief operating officer (COO), Tradejini.

 

Ajay Bodke, independent market analyst, suggests watching for working capital cycle manipulation through growing receivables and inventory alongside stretched payment terms to suppliers.

 

Assess profitability through return on equity and return on capital employed. Check leverage through the debt-to-equity ratio, including how much growth came from debt, whether pre-IPO growth relied on high-cost debt, and whether the balance sheet relies on leased assets.

 

Look beyond revenue and earnings before interest, tax, depreciation and amortisation (Ebitda). “In the long term, companies are valued based on free cash flow rather than sales, Ebitda, or earnings,” says Bodke.

 

High cash flow need not be treated as sacrosanct. Early-stage companies can have negative cash flows as they reinvest in the business.

 

Remember that IPOs have shorter financial histories. Equity analysis normally looks at five years or more of data, while an IPO may provide only three years of unlisted history. 

 

Do not overpay

 

Compare the price-to-earnings ratio with listed peers. “Peer comparison becomes less reassuring when peer valuations have got pushed to very high levels in a hot sector,” says Bodke.

 

Check the price/earnings-to-growth (PEG) ratio. Examine the growth assumptions built into the IPO price. “Be very careful when the IPO valuation requires an unusually high growth rate to justify the price,” says Kapur.

 

Be cautious in the case of cyclical companies. “A cyclical business priced off its best-ever quarter carries greater valuation risk for a long-term holder,” says Trivesh.

 

Tejas Khoday, co-founder and chief executive officer (CEO), FYERS, suggests that it is better to allow the initial froth to subside and invest later when prices turn more reasonable.

 

Probe promoters and governance

 

Study the promoter’s track record in listed and unlisted businesses. Past unfair treatment of stakeholders is a warning sign. Check for pending court cases and regulatory fines. Stay away in case of ethical concerns even when they are unrelated to the company coming to market.

 

Understand use of money

 

Read the objects of the issue in the prospectus. Distinguish fresh capital used to reduce debt or fund expansion from an IPO used by promoters and private equity players to reduce their stake.

 

A pure offer for sale brings no new money into the company. “Use of proceeds for growth should generally be viewed positively. Their use for promoter exits or other cash-outs may not be positive,” says Kapur.

 

Watch the allocation to “general corporate purposes”. “A large allocation to general corporate purposes can indicate unwillingness or inability to specify the reason for the fundraise,” says Bodke.

 

Dig into the prospectus

 

Use the prospectus to understand the business and its risks. “Read the risk factors and related-party disclosures,” says Trivesh. Focus on company-, industry- and macro-environment-related risks.

 

Study the financial statements. “Watch for possible dressing up of the balance sheet, profit and loss account, and cash flows before the company goes public,” says Bodke.

 

Look out for red flags

 

Be cautious with hot or sunrise sectors. “Strong short-term gains in a hot theme can be driven more by capital flows into the theme than by the company itself,” says Kapur.

 

A complete promoter exit is a major red flag. Even a large partial exit sends a poor signal. Obscure or lesser-known auditors are another warning sign.

 

Watch for churn in the company secretary, chief financial officer or CEO positions during the three to four years before the IPO.

 

Do not chase listing gains

 

Grey market premiums reflect short-term enthusiasm. Do not rely on them for listing gains. “Listing-gain expectations based on grey market premiums can rest on incomplete or erroneous assumptions,” says Khoday.

 

IPOs are not meant to capture listing-day gains. “The failure rate of pursuing listing-day gains is high because the approach is purely speculative,” says Khoday.

 

Do not borrow to apply

 

Borrowing for listing gains magnifies risk. “An IPO offers no guarantee of allotment or a positive listing return, while interest on borrowed money must still be paid,” says Abhishek Kumar, Securities and Exchange Board of India (Sebi)-registered investment adviser and founder, SahajMoney.com.

 

Finally, do not divert emergency funds to an IPO. “The liquidity risk from using emergency funds becomes worse if the stock lists at a steep discount,” says Kumar.

 

Seven key checks to run before investing in an IPO

• Check why the company is raising money and how the IPO proceeds will be used
• Assess the promoters’ and management’s track record, including governance and past conduct
• Examine revenue growth, profitability, margins, debt and cash flows over several years
• Review the working-capital cycle, especially receivables and inventories
• Compare the IPO’s valuation with listed domestic and global peers using appropriate valuation ratios
• Check for pending court cases, regulatory action, fines, auditor quality and senior-management churn
• Read the red herring prospectus (RHP) risk factors instead of relying on grey-market premiums or subscription numbers