Evaluating IPOs: Factors to Consider Before Investing

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An Initial Public Offering or an IPO is the process that a company, desirous of issuing its shares to the public for the first time, has to follow. Investing in the public issue of a company can be highly advantageous. You get to invest in a company during its early stages at an attractive valuation and may even get access to new investment opportunities that may not be available in the secondary market.

However, advantages aside, IPO investments are not without their risks. There are many instances where the public issue of a company has failed to live up to investors’ expectations. Such issues have ultimately become wealth destroyers rather than wealth creators. Here’s where evaluating an IPO before investing in it can help. Continue reading to find out more.

Factors to Consider When Evaluating an IPO

Careful evaluation of a public issue enables you to assess the potential risks involved and can help you make well-informed investment decisions. Before you proceed to invest in an IPO using your trading account, make sure to consider the following factors.

1.  Industry

As a prospective investor, it is crucial to get a good understanding of the industry the company issuing an IPO operates. When analysing the industry, make sure to look into its growth potential, entry barriers, regulatory roadblocks and competitive landscape.

A company that operates in a heavily crowded industry with little to no entry barriers will find it challenging to grow. Whereas, a company that operates in an industry with high entry barriers and little competition is more likely to do well in the future.

2.  Business Model

Once you’ve grasped the industry, the next factor to consider is the company’s business model. Look into how the company goes about its business and whether its model is profitable or not. A company’s business model should always be sustainable for it to have good growth prospects.

On the other hand, an unsustainable business model will most likely lead the company into financial troubles down the line. For example, a business model that requires the company to burn cash consistently year-over-year to gain a competitive advantage or attract customers is unsustainable.

3.  Company Fundamentals

The fundamentals of a company are one of the most important factors you need to thoroughly look into before deciding to invest in an IPO. Reading through the company financial statements should give you a fair idea of how the company has fared over the years.

Ideally, a company should have increasing revenue and profits year-over-year. Consistently declining revenue or profits, meanwhile, may indicate a faltering business. While analysing fundamentals, make sure to also assess the products and services provided and the market position the company occupies.

4. Management and Leadership Team

An experienced and able leadership team is essential for a company’s success. Therefore, spend some time evaluating the experience and track record of the company’s management. Also, it might be worth checking if the team has been with the company for a long time. Key Managerial Personnel that have only recently been associated with the company may not be in the right position to guide the business.

5. Strengths and Risks

Every business has its own set of strengths and risks. As an investor, you need to know what they are before you invest in a public issue. A good company should have more strengths than risks. Too many risks stifle growth since the management would be more focused on navigating the risks rather than expanding the business.

6. Use of the Proceeds

How a company plans to use the funds raised through an IPO can provide key insights into its future. A company should ideally use the funds raised for constructive purposes such as business expansion, acquisition or research and development. If it is for non-constructive purposes like reducing debt, a company is more likely going to want more funds once the debt is repaid.

Also, if there’s an Offer for Sale (OFS) from the existing shareholders, it is advisable to check the level of stake that they plan to offload. Shareholders planning to exit the company completely by offloading their stake via the IPO may be a sign of trouble.

7. Valuation

The valuation is one of the factors you should consider before placing a bid for an IPO through your online trading app. Some public issues tend to be valued optimistically. Such IPOs usually go through a major correction once they’re listed on the stock exchanges. Therefore, make sure to check if the valuation is supported by financial performance. You could also compare the IPO price with the industry average and the company’s peers for better context.

8. Market Sentiment

Market sentiment is often the most neglected factor when evaluating public issues. A positive market sentiment can do wonders for an IPO, whereas a negative market sentiment can lead even a stellar IPO to underperform in the short term. So, remember to check market sentiment before investing in a public issue.

Conclusion

The Draft Red Herring Prospectus (DRHP) is an extensive document that every company issuing an IPO publishes. It contains comprehensive information regarding the company, its business, financials, offer details and more. Always make sure to thoroughly read through the prospectus when evaluating an IPO.

Now, if you’re planning to invest in a public issue, you need to first open a demat account. Bajaj Financial Securities Limited is one of the leading stockbrokers in India offering a robust and feature-rich demat account app. With the smartphone app, you can quickly and seamlessly invest in your preferred IPOs and a host of other financial assets like bonds, debentures and mutual funds. Download the Bajaj Securities app today and open your very own trading account today!

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