Should You Invest in an IPO? 6 Factors to Consider

Investing in IPOs is showing a growing trend in India, attracting both retail investors and institutional players. A growing economy, coupled with the rise of Startup culture, has made IPO the most preferred source of raising capital for Indian companies to expand their operation. For the investors, an IPO would be an excellent vehicle through which to get in early in a company with growth potential.
However, like all investments, an IPO carries with it risks. Thus, a prudent investor will analyze a company’s fundamentals and look into the industry trends before coming to a decision to make the investment. In this article, we will analyze the factors that an Indian investor has to take into consideration before making investments in an IPO.

What is an IPO?

An Initial Public Offering (IPO) is referred to when a private company issues its shares to the public for the first time through the primary market. This is one way by which a company can raise funds from a wide base of investors. For investors, this opens an opportunity to invest in a company at the start of its journey as it goes public. IPO allows an investor to buy shares at potentially lower prices and this can lead to really nice returns if the firm happens to do well in the future.

However, it is important to understand its nuances before actually investing in an IPO.

Key Factors to Consider When Investing in an IPO in India

A company’s strong fundamentals are the cornerstone of any good investment. Here’s what an investor should look at before making an investment decision.

Fundamentals of the Company

Financial Health: First and foremost go through the company’s financial statements, which are included in the IPOs’ Red Herring Prospectus (RHP). Revenue growth of the company, along with its profitability, debt levels, and free cash flow of the company are all key metrics to consider before investing in an IPO. The company should have shown consistent revenue and profit growth in the past.

Business Growth: Analyze the business model of the company and how sustainable it is in the Indian context. What has been the revenue-generating strategy of the company? How will it sustain the revenue growth over a period of time? How is it planning to grow in such a competitive market in India? Companies that are well-defined with their strategy and business model will always be ahead of the curve when market fluctuations happen.

Industry Trends in India

Industry trends do have a bearing on the success of an IPO. The following factors should be taken into account before investing in an IPO.

Sector Growth: Know the growth prospects of the sector to which the company belongs. An investment in a company from a sector poised for growth will fetch better returns.

Competitive Landscape: Check out whether the company has competitive advantages in the industry or not. Does the company own an innovative product, is it a recognizable brand, or possesses proprietary technology so as to be differentiated in its industry? A strong competitive advantage is important for growth

Regulatory Environment: The knowledge regarding the regulatory environment and the associated risks in which the company operates is needed to assess the long-term potential of the company. For example, companies operating in the telecom, finance, and healthcare industries mostly face severe regulations.

Indian Market Scenario

The market scenario is also one of the key determinants of an IPO’s performance. Here is what the Indian investor needs to keep in mind:

Market Sentiment: IPOs do well when the markets are positive, that is when the investor sentiment is positive. Check the performance of Nifty50 and Sensex regularly. If the markets are volatile, it will be better to approach an IPO with caution.

Timing: To gain valuable insights, know whether an IPO is launched in a bullish or bearish phase of the market. Companies with IPOs in a bullish phase tend to be more confident in their valuations. Conversely, IPOs during a bearish phase of the markets might be raising funds due to challenging conditions.

Interest Rate: The monetary policy of the Reserve Bank of India affects the behavior of investors. When interest rates are low, investors want to invest to make higher returns through equities, that includes IPO. In case the interest rate is high, investors become risk-averse.

Prospectus and Red Flags

For an investor, the Red Herring Prospectus is the most important document. It is an official document containing all the required information about the company, this includes the financials of the company, its business model, and the risks associated with it. Here are the red flags to look out for:

Unclear revenue model: Analyze the revenue model of the company; does it present a clear path to profitability? It is better to avoid IPOs wherein the company’s revenue model appears overly optimistic and relies too heavily on future projections.

High dependence on only one product or very few customers: If the business revenue is majorly dependent on a single product, or on a single handful of customers, then it could face trouble if the dynamic of the market changes or people start turning towards the rivals.

High debt: A firm with a lot of debt may weaken its health. Businesses that have debt-to-equity ratios in excess of the industry averages are likely to fail at controlling costs in an unpredictable economy.

Lock- Up Period

Few IPOs come with a lock-up period during which promoters, insiders, and early investors are restricted from selling their shares. As an investor keep an eye on the lock-up expiry date, as it may at times lead to sell-off after the expiry date impacting the stock price. If you plan to hold the shares of the company for the long-term a dip in the share price could present a buying opportunity.

Institutional Investor Participation

High participation by Institutional investors, like Mutual funds, Foreign Institutional Investors (FIIs), and Domestic Institutional Investors (DIIs) can be a key indicator of an IPO’s potential. It also signals that the IPO has undergone rigorous scrutiny. However, heavy institutional involvement can also result in short-term volatility, as large investors may move out quickly after making gains.

Advantages and Disadvantages of Investing in an IPO in India

Advantages

Early Entry: An IPO allows an investor to invest in a company before it trades publicly. It gives an investor a chance to buy shares in a company at a relatively lower price with the expectation that it will yield a higher return if the stock performs well after listing.

Growth Opportunities: Many industries in India such as fintech, technology, and renewable energy are growing at tremendous rates. This means, if you invest in any of these sectors, you’ll be expected to get good returns on your investment amount.

Diversification: Through IPOs, a portfolio can be diversified as it gives a chance to invest in various sectors or companies that were hitherto unavailable in the Indian stock market.

Risks

High Volatility: In the initial period of listing, the price of the new stock that has been listed can be highly volatile since the market finds a fair value for the new stock.

Limited Historical Data: Since IPOs are new to the public markets, there is limited historical data available, which makes it challenging to predict performance

Overvaluation: Market hype may overvalue the IPO, leading to poor performance post-listing if the market corrects the price.

Research Tools and Resources for Indian Investors

There are quite a few tools available that help Indian investors evaluate an IPO.

SEBI Filings: All Companies coming up with an IPO have to file their prospectus with The Securities and Exchange Board of India (SEBI). The Red Herring Prospectus document available on the SEBI website gives a wholesome view of the company.

Financial News Portals: There are a number of News websites that publish detailed information regarding Indian IPOs.

Broker Reports: A number of SEBI-registered brokerage houses publish detailed reports on the forthcoming IPOs. These reports may provide extensive knowledge regarding the potential risks and returns.

Conclusion: Should an Indian Investor Invest in an IPO?

The returns that can come from an IPO are attractive, but it is not without risks. It is important for an Indian investor to understand the company’s fundamentals, industry trends, and in general market conditions. While it could be tempting to participate in a new listing, a research-driven approach is necessary.

By using authoritative sources to evaluate the IPO, diversifying your investment and aligning the financial goals will help you to make informed decisions. Investment in IPO must be part of some well-diversified approach in order to minimize risk and maximize profits.

Happy IPO Investing!