Why understanding valuations is key to IPO investing

Publish Date: September 12, 2018

Initial public offering (IPO) activity has picked up in recent years. Over Rs 1,00,000 crore was raised in last two years. Domestic markets are enjoying a super-cycle of liquidity. Robust IPO activity has created many maiden investment opportunities for the discerning investor. We must remember that India got massive Private Equity (PE) and Venture Capital (VC) investments from 2010 to 2015. These were times when capital raising through the public market was difficult. As the IPO market has become active now, most PE/VC investors are planning their exits. But, not every IPO can give you bang for your buck. Out of the 19 IPOs that have got listed in 2018 so far, 11 are trading below their respective issue prices. This means it is very important to buy the right IPO at the right price. Let us understand the important factors that should drive your IPO investing journey.

Process Driven Approach

You need to to have a process driven approach to IPO investments. Investors should avoid making investment decisions based on hearsay. A process ensures that there will be a good selection of quality companies. Automatically, exit management becomes systematic, with an eye on maximizing stock returns.

The beauty of having a clear process lies in being able to avoid shocks. Resist the temptation of going for short-term bets. In the world of equity investing, the ability to avoid bad investments is far important than getting the opportunity to invest in good ones.

Over long periods of time, bad investments drag down the return of a portfolio. They also lead to improper allocation. This means bad stocks not only bring losses. They also limit the allocation of money to good stocks that perform well.

In-depth IPO analysis

It is important that you do an in-depth analysis of the IPO. Such analysis helps in selecting firms with fundamentally strong foundation. Companies will always differ in terms of character and financials per the vagaries of their respective sector. But IPO investors must maintain the discipline to maintain a high margin of safety. This is where valuations become very important. As the great Warren Buffett says, price is what you pay, value is what you get.

Valuation is not a mere number in isolation. For instance, a company trading at 20 times trailing earnings is not necessarily better-value than one trading at 25 times. A high margin of safety in pricing and your entry point in the IPO will ensure value creation. This will ultimately translate into investor returns. You will have a margin of safety when their price is below their intrinsic value.

Apart from valuations, as an IPO investor, you have to keep in mind the company's market leadership, return on capital employed and return on equity, earnings per share and revenue growth, long-term business fundamentals, promoter quality and governance checks.

Judicious and agile investing

New sectors are being introduced via IPOs offering unique opportunities to play India’s growth story every other week. If the equity markets remain buoyant, it is likely that the number of IPOs hitting the market will remain at this level.

This calls for both caution and agility. A regular number of IPOs, and concerted buzz around them will be attractive. Yet, it is very important to be able to separate the wheat from the chaff. While investing in maiden IPO opportunities does sound exciting, it is important for you to follow the process. If the IPO-bound company, its selling shareholders and investment bankers do not leave any value on the table, there is no point in buying that stock at such a price.

On such occasions, it may be worth your while to wait for the IPO stock to get listed and then review its performance. Many a time, IPO issues after listing trade at deep discounts after the initial euphoria is over. In such instances, agility is of the essence. This is because efficient markets do not allow mispricing opportunities to exist for long times.

In conclusion, IPO investing is a lot more fun once you have a framework for investing and follow it. A clearly defined process that looks at the valuation, business, management, and quality is going to stand any test of time.

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