Evaluating an IPO

Buying into an IPO with a long term perspective requires an examination of the fundamentals of the company. The main parameters can be divided into the 4Ps – Promoters, Performance, Prospects and Price.

Promoters: A strong management track record is a very important factor during evaluation – management experience in the industry and performance of other companies managed by them. Ensure that the promoter’s track record is clean and any investor complaints and litigation against the promoter do not jeopardize the future of the company. A record of the lawsuits is divulged in the DRHP and also in a website called www.watchoutinvestors.com.

Performance: For a basic evaluation, look at the ratio of debt to equity and also compare income to expenses. A healthy standing in the above two metrics is a positive indicator. A comparison of the debt-equity ratio to the peers in the industry gives a sense of whether the company is optimally leveraged. Calculate Return on equity (Profit after tax divided by Shareholders’ equity), net profit margin (Profit after tax divided by Sales), EBIDTA and ensure that the metrics are not below the industry average. Also, look for performance consistency. Be cautious of unexplained spikes in profits or sales the year before the IPO. Make a close study of the numbers to spot possible “bloating”. Look out if the bulk of the profits comes from “other income”, if there are changes in accounting policies (reducing depreciation reduces the tax liability and buoys the profit after tax) and significant notes to accounts. Note the presence of patents, trademarks, copyrights etc that protect the business.

Prospects: Understanding the company’s long-term prospects is key. One tool you can use is the IPO grades issues by credit rating agencies like CRISIL, which will be included in the prospectus. These grades are assigned on a five-point scale. Higher grades suggest stronger fundamentals. IPO grades consider factors such as the industry, the company’s financial position, competitive advantages, quality of the management and legal issues such as litigation. But a high IPO grade cannot be construed as a recommendation to buy. Also, do note that a SEBI approval of the DRHP only mandates that the information in DRHP is authentic. Make a first-hand study of the risk factors disclosed in the prospectus like concentration of earnings, number of big customers and how they are geographically spread.

Price: The offer price of an IPO is an important factor in determining your potential gains. You can evaluate the offer price by studying the price earnings ratio (PE ratio – current stock value divided by EPS). It can tell you how expensive the stock is. Higher the PE multiple, more expensive the stock. Don’t go by the absolute value of the stock to determine its worth. Also, PE as a standalone number is not useful. Compare PE to the company’s peer group and also to the broader market. You can also use the Price-Earnings-Growth (PEG – PE ratio divided by the expected earnings growth %.) to see if the share is underpriced or overpriced. The PEG ratio determines a stock’s value while taking future earnings growth into account. If the PEG ratio is more than 1, then the share may be overpriced as compared to the anticipated earnings growth. This may be due to excess enthusiasm in the market for the stock. If it is below 1, then the share may be underpriced as compared to the anticipated earnings growth. This indicates a value buy.

Some final words of caution – don’t get enthused by subscription numbers. This is mostly dependant on market sentiments and is not indicative of fundamental strength and don’t get deflated by lacklustre performance during the intial days of the IPO.

Some of the most successful companies like Coca Cola and Bharti Airtel had a choppy ride during the first year but are now counted among the best stocks.

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