Despite the many risks, it is likely that IPOs will continue to attract investors because they are usually issued by firms in a transitional phase

Bombay Stock Exchange (BSE) is the oldest stock exchange.  It has around 5,000 companies listed with it. On the other hand, the National Stock Exchange, which is comparatively a newer exchange, has around 2,000 firms listed with it. Companies range from Goliaths like TCS and Reliance with market capitalisation crossing the Rs 8 trillion mark, to inconsequential companies with market capitalisation as less as the price of a car. Companies had to start somewhere. Each sprang to trading as Initial Public Offerings (IPOs), a process where a previously unlisted company sells new or existing securities and offers them to the public for the first time. Prior to an IPO, a firm is considered to be private — with a smaller number of shareholders, limited to angel investors, venture capitalists and high net-worth individuals; and/or early investors, for instance, the founder, family, and friends. After an IPO, the issuing company becomes a publicly listed company on a recognised stock exchange. Thus, an IPO is also known as “going public.”

Although consumers are on the lookout for the next big thing, IPOs can be difficult to gauge ahead of their listing and incredibly volatile when they hit the market, but are a potentially lucrative investment if done right. But just as with any share, potential buyers need to sort out the firms offering good value, with staying power to thrive in public market from those where red flags could spell disaster. A company’s prospectus will give some of the best clues to the underlying business. It should lay out what the company does and what it hopes to do with the money raised. Details about the management team will also be made available. Investors need to feel comfortable with the business they are buying into and should be aware of any factors that could push them to walk away.

One of the first factors would-be investors need to consider is whether or not they like the company and believe that it has room to grow. The listing business should have a sound business model with a strong competitive edge in its market that differentiates it from peers. Investors should feel they understand why a customer would want to pay for the products/services offered by that specific company as opposed to others that offer something similar, especially if its competitors are more established or well-known businesses. As with any other company an investor is looking to buy shares in, discipline is required when assessing the company’s strategy, competitive position, finances and the ability of the management team to run it properly.

A more established business may fare better on the public market than one that has less of a track record. Another important question to ask is about the investment plans by management on having access to funds, whether it will be to fund expansion plans or pay off existing debt, or some hybrid of the two. The former is often preferred since shareholders are often encouraged by a business that can demonstrate that it has plans to become bigger. However, paying down debt also frees the firm from the burden of interest payments, allowing it to invest in its core strategy and to improve its business model and efficiency.

Third, a trustworthy and reputable management team, with a good track record, is a must have. Becoming a public company is a significant step in the life of a business and a big commitment for management to take and so the team must communicate clearly with new shareholders and deliver on the promises.

There are some criteria which show that the companies are in good shape before investing in the IPOs:

• Debt should not be more than twice of the profits.
• 10 per cent earnings growth forecast for 12 months.
• Earnings growth of at least 10 per cent during last two years.
• A healthy flow of free cash flows.

An IPO is a key milestone in a firm’s life cycle and a healthy IPO market is important for many reasons. IPOs give entrepreneurs liquidity for investments, so a vibrant market can stimulate and help develop new ventures by bringing new investors to a firm, which facilitates its access to future growth capital. Being public also reduces the costs of raising future capital by stimulating the supply of information from the investment community. IPOs are significant as they are regarded as the barometer of the health of the capital market. A single bad IPO can create considerable market disruptions and stall the plans of other firms that want to go public.

Despite the risks, it is likely that IPOs will continue to attract investors because they are usually issued by companies in a transitional phase. Companies in transitions are exciting and interesting to investors. The prospects for a big win and the possibility of earning millions can be very enticing. Just make sure you understand the risks before you take a chance.

(The writer is Assistant Professor at Amity University)