Investing 101IPO Review

Initial Public Offering: Meaning , Life Cycle , Pricing of IPO and FAQs.

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In the recent times , you would have heard the word Initial Public Offering(IPO) many times. Be it newspapers , analysts , news anchors and your friends. Today we see in detail what IPO actually is , how it works and I will also answer some of the generally asked IPO queries.

Meaning of an Initial Public Offering:

An initial public offer of shares or IPO is the first sale of a corporate’s common shares to investors at large.  The main purpose of an IPO is to raise equity capital for further growth of the business. Eligibility criteria for raising capital from the public investors is defined by SEBI in its regulations and include minimum requirements for net tangible assets, profitability and net-worth. SEBI’s regulations also impose timelines within which the securities must be issued and other requirements such as mandatory listing of the shares on a nationwide stock exchange and offering the shares in dematerialized form etc.

Fund Raising Options:

The IPO Life-cycle (From company deciding to go for an IPO to the company getting listed on exchanges):

How are the IPO Prices decided?

There are 3 stages of price discovery of a company issuing an IPO.

Stage 1:

When the company wants to do an IPO it hires investment bankers or Book running lead managers who file their IPO Prospectus with SEBI and also they decide the price band of the IPO. Now this price band is arrived by a process of book building . The investment bankers investigate the company financials , its peers , its management and also they decide on a price band. For example if XYZ is in textiles sector , they look at their business earnings and listed peers and they decide a price band of 500–700.

Stage 2:

After investment bankers decided the price band of 500–700 they take this company’s data and price band to market makers such as Mutual Funds , PE investors etc and build a book of demand and price. Suppose they got maximum demand in the price range of 530–620. This is the IPO price which is decided for the IPO. Do note this is all pre-IPO stage. Now the company comes out in the market with its IPO with the bid range price of 530–620 rupees.

Stage 3:

Now the company’s IPO opens in market with the price band of 530–620 rupees. Now again a question comes that how is the listing price on the listing day decided?

Again the demand and supply is taken into account and the price at which maximum demand has come will be the cutoff price. So in this case maximum allocable demand has come at 585 rupees and hence this is the price at which the share will list. After it lists the market forces of demand and supply will take the share price up or down.

If there is more supply than there is demand , share prices will fall and if it is vice versa share prices will rise.

Frequently asked Questions and their answers:

Why does price of IPO companies skyrocket after their listing?

I believe stock prices skyrocket for IPOs mainly because of two reasons:

Market is Overvalued

Suppose there is a bull run going on in a country’s stock markets. It is then obvious that people will shy away from investing in bull markets as valuations are overstretched. Hence when a new company issues its IPO and when it lists there is a frenzy to buy the company’s shares. Again this happens only sometimes because it is quite possible that the company’s IPO itself may be overpriced. This usually happens because IPO issuing companies know there is heavy demand for shares during a bull run.

Demand Supply Law

What happens in IPOs is that the supply stays same but the demand is huge for the same amount of shares and hence people start putting more and more premium on the shares to buy them. Hence when the IPO lists on the stock exchange it does so with a huge premium. This is famously referred to the IPO ‘Pop’.

What is an IPO Prospectus?

IPO Prospectus is also called an offer document.

Capital Markets or ideally Primary markets help a company raise capital (for a stake in their company) or borrow money (in exchange for interest payments and principal repayment) from investors for the first time. An offer document, as the name suggests is a document prepared by the company for the various classes of investors when they are raising capital from the Primary Markets. An offer document contains vast amount of information. An offer document contains things such as:

  • Risk Factors in the Issue
  • Investment bankers to the Issue
  • Registrars to the Issue
  • Issue Open and Close Date
  • Pricing of Issue
  • Opportunities in investing in the Issue.
  • Company Strengths
  • Company Strategies
  • Objectives of the Raised Capital.
  • Information of Company Management (Remuneration and DIN)
  • Equity Capital and Share Issuance History of Company.
  • Balance sheet for the last 3 -5 Years.
  • Profit and Loss Statement for the last 3-5 years.
  • Cash Flow Statement for the last 3-5 Years.
  • Company Financial Ratios such as Return on Net Worth, Price to Earnings , Price to Book Value.
  • Peer Comparison.

The Significance of Offer Document is that it helps an investor to get the complete picture of a company going for capital raising. This is important because:

  • It helps investors to take an informed decision of investing or not in the Issue.
  • It helps investors to save time as the investor does not have to consume a lot of time researching the quantitative and qualitative factors of the company.
  • An Offer Document is first reviewed and audited by independent Auditors appointed by the company and then the offer document is submitted to the Market Regulator: Securities and Exchange Board of India. Only after SEBI reviews and approves it, the company is allowed to raise capital in the Market. Hence an offer document has enormous importance since SEBI will vet it line by line. This is to check for fraudulence and also to instill investor confidence.

What is the sureshot way to get an allotment for the IPO?

There is no sure way to get allotment for the applied IPO. In case of over-subscription the registrar to the particular issue does a lottery draw and allots the securities. For Instance if there is 10 times over-subscription in Retail Investors Category only 1 out of 10 people will get their applied shares. And even that 1 person will be chosen randomly. So it all depends on your luck.

What exactly is the difference between an SME IPO and a regular IPO? Is there any risk in applying to SME IPOs?

The minimum investment: The minimum investment in Normal IPO is 12,000 to 15,000 INR. On the other hand for SME IPO it is 1,20,000 to 1,50,000. This is because only long term and capital intensive players are allowed for SME IPOs. The main reason for this rule is that SMEs are upcoming businesses and volatile and impatient investors may hammer a listed SMEs market cap.

Business Roles: Normal IPO companies may have clearly defined business roles such as CFO, CTO , CEO , CXO whereas it is would not be surprising to see 2 major roles to be handled by same person in an SME.(as the company size is small)

Underwriting: Full underwriting is compulsory in SME IPO whereas underwriting in normal IPO depends on the issuing company.

Allottees: Allottees should be more than 200 in SME IPO whereas in normal IPO certain percentages are set.( For Retail Investors , Non-institutional Investors and Qualified Institutional Buyers) and no certain allottee number is pre-defined.

If an IPO is undersubscribed, does anyone lose money? How does this work?

If an IPO is under-subscribed no one loses money because the IPO going company has to refund the amount to the investors who had applied.

Best Example: Green Signal Bio Pharma

The initial public offering (IPO) of Chennai-based pharmaceutical company Green Signal Bio Pharma failed to go through on the final day of the offering as institutional investors stayed away.

The timeline for IPOs is typically three days. Green Signal had extended its IPO timeline twice — from November 11 to November 17, and then from November 17 to November 22, 2016. (Even parag milk foods had extended its IPO deadline , however the IPO got through)Besides extending the timeline for the second time, the company also lowered its pricing on November 17 from Rs 76-80 a share to Rs 68-76 a share, and was hoping to raise Rs 110 crore at the upper end of the price band.

Minimum Subscription

The minimum shares the company needs to get from the public out of the total issue by the date of closure. (Presently every company need to raise 90% of the issued amount). Else, the company shall refund the whole amount received. This 90 % has to be exclusive of the cheques that are not cleared or the ASBA application amount in current scenario.

It’s the Company’s Loss

It may look like that the investors didn’t lose money and the company didn’t get the money. Nothing great in that , right? But actually the company gets a very negative publicity in the markets because it shows that the investors are not interested at all in buying the shares of the company which eventually lowers its reputation , even if it is a good company. ( also they may lose some money in investment banking expenses , investor roadshows , prospectus filing charges with SEBI and more , if any.)

They may not lose anything tangible but they may lose out on intangible things such as Customer loyalty , goodwill.

During IPO bidding, where is the blocked amount of investors stored until shares have been allocated to them?

The amount is stored in the investor’s account itself.  ASBA stands for Application supported by blocked amount , the amount merely gets blocked till the time of allotment.If you get allotment , money will be deducted and if you don’t get allotment money will be unblocked.

For instance if you apply IPO shares worth 15,000 from your bank account which has 15,100 rupees , when you check your balance it will just show 100 rupees. If you don’t get allotment balance will be 15,100 again.

Who are the Participants in an IPO?

Should Retail Investors apply in IPOs?

Before Investing in IPOs , you should understand about the business of the company , its past financial performance , purpose of raising capital , quality of management etc. If the IPO checks out on all the parameters set by a retail investor , they can invest in an IPO.

What is difference between Offer for sale(OFS) and Fresh Issue?

OFS: PE , promoters , venture capitalists or HNIs who invested in company at a early stage are converting their non-traded company shares into tradeable shares by selling it to public via an IPO. In a nutshell privately held shares are now being made public via IPO.

The only problem here is that the money raised through OFS won’t affect the company at all , since they would not get any money from the IPO , the exiting investors will get the money.

OFS may have an adverse effect on prices of shares and the reputation of company if:

  • Famous Investor/Fund House exits the company via OFS
  • Famous Investor/Fund House exits the company via OFS at a discounted price

Again , this is just a hypothetical situation. The actual reaction of market may vary. ( Many PSUs have done their OFS but still the share prices have fared well in the long run)

Fresh Issue: Company is issuing new shares (which dilutes the present shareholding stake of all shareholders) but the money raised from fresh issue of shares will be all received by the company unlike OFS.

Interesting news on Offer for sale:

India’s record year for initial public offerings so far hasn’t made the companies richer. It’s the promoters and investors who cornered the bulk of the gains.Of the Rs 29,000 crore raised in more than two dozen IPOs, 84 percent came from stake sales by existing shareholders. Companies got the remaining 16 percent by issuing new stock, the lowest in at least 29 years. (Source)

What are the things to look for in an IPO before investing?

  • Price band for IPO is not overpriced(an overpriced issue automatically shows that the exiting investor or management is greedy for money and would not even leave money on the table for investors). D mart IPO was priced such that ample money was left on the table for investors. This speaks highly of Mr Radhakishan Damani.
  • It should not be an offer for sale. Offer for sale means that the company would not get any money raised from IPO , but instead the exiting investor will get all the money. ( On the contrary some Public sector companies’ OFS sailed through nicely. Ex: HUDCO )
  • It is highly important that you check how the proceeds raised from the IPO will be used. If company says only debt will be repaid , then it is not such an attractive option , but if company says they will partly pay debt , open a new factory or general corporate purpose , then it shows that money will actually flow in the business which is good for an investor.
  • Some Financial Metrics: Debt to equity , RoE , RoA , RoCE , Promoter Holding , Cash flow analysis and so on.
  • The Sector should be a growing sector so that company can perform better in the future.
  • Do peer analysis to check if company is overpriced or not. Peer Analysis also helps you to know how much company has captured the market with respect to its peers.
  • Many People buy IPOs solely for the ‘IPO pop’ (IPO pop means monetizing on the premium listing of the stock on exchange). This also influences the stock to move wildly in the starting couple of weeks. The stock may rise rapidly or fall rapidly but if you have strong conviction , hold on to the stock because the price will reflect its true value only in the long term.

Is it profitable to invest in IPOs for the long term?

So it was beneficial for me for holding stocks for the long term. Some of my IPO long term holdings include:

  • RBL bank bought at 225 , now trading at 522.
  • Indigo bought at 765 , now trading at 1158.
  • Endurance Technologies bought at 472 , now trading at 1100.
  • Equitas Holdings bought at 110 , now trading at 152.

How does one increase chances for allotment?

Apply for IPOs from demat accounts of different family members. This ensures a higher probability of allotment. For instance if there is 10 times oversubscription and if you have only applied through one demat account your allotment chance is 10% but if you have 10 demat accounts and you have applied through all of them then your allotment chance is 100% (10% on each demat account , 10% into 10). This means you are bound to get one lot of allotment in one of the ten demat accounts for sure.

If shares are allotted , should you exit immediately on the listing day?

This depends on your strategy , some IPOs are good to hold for the long term whereas some are just good for the short term. For Instance I held onto my RBL bank shares which were allotted to me during IPO because I saw long term prospects in this bank. On the other hand I sold my BSE shares on the listing day since BSE faces stiff competition from NSE.

Who are Anchor Investors?

You would have seen anchor investors name popping up before an IPO opens for subscription. Some examples of such news:

Ahead of IPO, Matrimony.com raises Rs226 crore from anchor investors

Dixon Technologies raises Rs 179.8 crore from anchor investors

Prataap snacks raises rs 143 crore from anchor investors

Anchor investors or cornerstone investors (as they are called globally) are marquee institutional investors like sovereign wealth funds, mutual funds and pension funds that are invited to subscribe for shares ahead of the IPO to boost the popularity of the issue and provide confidence to potential IPO investors. Anchor allotment is done a day before an IPO opens. Roping in anchor investors gives a lot of comfort to the issuer and banker, as nearly a third of the IPO gets covered even before the opening day. A healthy anchor book also gives lot of comfort to small investors as it indicates the faith shown by institutional investors, say experts.

If you have any unanswered IPO queries , please do drop a question in the comment box.

Thanks,

Aditya Kondawar

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2 Comments

  1. […] Initial Public Offering: Meaning , Life Cycle , Pricing of IPO and FAQs. […]

  2. If I don’t get allotment for any IPO, so at what point should I buy it from secondary market?

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