Five Minutes to Understanding IPOs

An Initial Public Offering (IPO) can be a good investment avenue for equity investors. While the IPO market is dry these days, a fresh crop ...

An Initial Public Offering (IPO) can be a good investment avenue for equity investors. While the IPO market is dry these days, a fresh crop is expected soon. Let us take five minutes to understand IPOs and to decide whether to invest in them or not.

What is an IPO?

Suppose your friend owns a business, his company is profitable and he wants to grow the company faster. For this he needs money. Instead of debt, he wants to offer a part of his company for sale in the stock market. He will make, what is called, a ‘public offer’ of shares (after a number of procedures and regulatory processes). If the issue is successful, his company will ‘list’ or begin to trade in a stock exchange. So, an IPO is a fresh offer, where a company that is not yet trading, wants to sell shares directly to the investors. The shares can be offered ‘at par’, that is, at face value of Rs 2 Rs 5 or Rs 10, or at a premium. After this, your friend is no longer the only owner but will have ‘diluted’ his share. The ‘owners’ of the company may now be thousands of people he may not even know. Yet, if he holds the majority shares, he will still take all the decisions about the company. All the share holders are now entitled to vote, may get dividends and bonuses. They also have the option to exit from the shares by selling their stock in the secondary market, making a capital appreciation or loss as the price changes from the issue price.

Why buy an IPO and not through the secondary market?

With an IPO you get a shot at buying a tree when it is just a sapling. A fully grown apple tree may cost Rs 500. But an apple sapling may cost Rs 5. A half-grown apple tree that is yet to bear fruit may cost Rs 100. By buying a sapling whose value may grow to Rs 500, you are buying cheap today something that maybe of value tomorrow. You may even be buying seeds from an existing fruit-bearing tree. But you need to have some knowledge of apple trees, horticulture and apple markets before you can identify a sapling with potential. IPOs are the same. You have a chance to part-own a business before it has fully grown or in a grown company’s expansion plans. Investors who saw the potential of Infosys or Satyam and bought little saplings, now own fully grown fruit-bearing trees.

What to look for in an IPO

You need to filter out the hype from the offer and go for a company whose business you understand. Don’t buy a telecom company if all you know about telecom is how to use a mobile. Look at the company making the offer and its track record in terms of performance in the last three years. Look for a strong professional board of directors. Analyse the status of the project – is it fully operational or half completed. Read the risk factors (both internal and external) in the offer document. Consult your financial advisor or broker if you have any doubts. The company should follow good corporate governance norms and offer transparency in their operations. The market regulator has tightened the norms governing IPOs and put stringent entry barriers to companies entering the market, yet, do your due diligence before you buy.