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Five questions to ask before you invest in an IPO

Investing in equities is one of the best ways to grow your capital to reach your financial goals. You can either invest in equities through the secondary market, where you buy shares that are already traded in the market or you can invest in the primary market through an IPO or Initial Public Offer.

IPO investments are generally considered very risky since the market has not evaluated the performance of the company. In some cases, the shares lose their value on getting listed and that may take years to recover. However, there are benefits to this as well. The company shares may skyrocket in sometime and you may earn huge profits as well.

It is possible to make smart investment in IPOs by asking a few questions before you invest. IPO investment is not simply investing in a popular issue. It is a legitimate way to increase your earnings through capital gains and dividends. This is why it is better to know the company before putting your funds in it.

Here are 5 questions to ask before you invest in an IPO:

1. Company financials:
Before putting in your hard earned money in an IPO investment, it is important to look at the company financials. There are a few indicators that you can check as a potential investor:

  • Sales, operating profits and net profits quarter on quarter
  • Expenses and composition of expenses such as sales expenses, administrative expenses, depreciation
  • Debt levels
  • Assets
  • Cash and cash equivalent balances among others

To evaluate the performance of a company, there are certain financial ratios that you can calculate. These ratios measure the performance of the company in terms of utilisation of assets, composition of assets, financial health etc. Some important ratios to calculate are:

  • Debt equity ratio which calculates the ratio of debt and equity in the company’s balance sheet. The ideal debt equity ratio is 2:1, which means the debt should not be more than 2 times the equity of the company.
  • Return on Equity ratio measures the income earned for the shareholders. This ratio can be compared for each year to find out whether the company is growing its earnings.
  • Current ratio measures the ratio of current assets to current liabilities. This helps to understand whether the current assets will be enough to meet the current liabilities when they fall due. The ideal current ratio should be 2:1 at the least.
  • Quick ratio measures the quick assets i.e. current assets without illiquid assets such as inventory and debtors against current liabilities. The ideal quick ratio should be 1:1 ideally.

By evaluating these ratios, you can get an idea about the financial performance and health of the company. This can help you decide whether the investment is worthwhile or not.

2. Peer performance:
This is a crucial indicator while making an investment decision. Peer performance should be evaluated in a similar manner to the company’s performance i.e. by checking financial ratios and the expense and income figures. An important part of this analysis is to also look into the sector in which the company is operating. If the company is operating in a distressed sector, or a sector facing a lot of structural issues, it is probably better to avoid investing in the IPO and decide to invest at a later date.

3. Share valuation:
Each company that is about to list puts out its share valuation. There are different types of issues; fixed price issues where the price is decided and a book building issue. In the book building issue, the share price is usually set up as a price band and the final price depends on the different bids received. The cap price is a maximum of 20% of the floor price. The company has to disclose the basis for valuation of shares in their prospectus. The prospectus is available on the stock exchange websites and on the company website.

4. History of the company:
This doesn’t refer to just the financial performance of the company. It also refers to how the company grew to its present size. It also includes information about the company promoters and the current management team. A company’s management can go a long way in determining its future success.

One way to find out about the history of the company and its current and future growth potential is to read the annual reports of the company. As a part of the Director’s Report, there is generally an exhaustive summary on the company’s past and an outlook for the future. It also briefly touches on the management. It is important to look at the number of directors in the company, especially independent directors. The reason for doing such exhaustive fundamental research is because a strong management team will ensure funds are used properly to grow the company.

5. Fund usage:
As per SEBI rules, a company that wants to list its shares on the stock exchange has to disclose the usage of funds in the prospectus. It is important to verify the reason for the company’s listing. A listing is essentially a fundraising exercise. If you’re recommended investing in a particular IPO, you can question before investing in IPO. Most companies use the funds for their growth and expansion.

Besides the above 5 factors, there are numerous other small points that you may want to consider before investing in an IPO. Wondering where you can find these? Well, you can refer to the research reports by experts in the field. You can find such reports from IndiaNivesh Ltd. and you can get them by opening an account with IndiaNivesh Ltd.

If you’re wondering how to invest in IPO in India, there are two ways:

  • Offline investment
  • Online investment

In an offline investment, a form needs to be filled up by the investor and share ASBA account details. This needs to be submitted to your broker who will enter it in the system and submit your application.

Online investment in an IPO is possible through your trading account. If you’re thinking on how to invest in IPO online then you can check your online trading account for an option to put in a few lots. Once the issue is closed and shares are allotted, the money will get debited from your bank account.

By making sure you do adequate due diligence, you can ensure you use an IPO to grow your capital.



Disclaimer: Investment in securities market / Mutual Funds are subject to market risks, read all the related documents carefully before investing.