Investing in an IPO can seem exciting. The entry of a new company into the stock market generates significant buzz, attracts media attention, and sometimes yields massive profits upon listing. However, many beginners end up losing money due to a lack of proper research. If you truly wish to invest wisely, you must learn how to analyse an IPO before committing your capital. Applying blindly based on news reports, social media tips, or Grey Market Premiums is a risky endeavour.
In this guide, you will learn step-by-step, how to analyse an IPO before investing, enabling you to make informed and confident decisions.
What is an IPO?
An Initial Public Offering (IPO) is a process through which a private company transforms into a public company by offering a portion of its ownership for sale in the form of newly issued shares. This provides public investors with the opportunity to purchase equity, and the company’s stock subsequently becomes tradable on a public exchange.
Beyond raising substantial capital for growth or repaying debt, this process offers founders, early-stage investors, and employees the opportunity to realize profits on their investments.
However, an IPO is a journey, not just a single event. It usually starts when a company selects an investment bank to underwrite the deal and help with valuation. Next, the company conducts an audit and prepares regulatory filings (such as the S-1 in the U.S.). It then refines its financial projections and performance metrics and organizes one or more roadshows to attract public interest. After that, the company determines the final offering price and manages key aspects like lock-up periods and quiet periods. Once trading begins, the company aims to stabilize and continue growing.
Types of IPOs
There are two common types of IPOs. They are as follows:
Fixed Price Issue
In this method, the company and its underwriters analyze the company’s liabilities, assets, and other financial information. Subsequently, they determine the price per share for the issue in a manner designed to raise the targeted capital. The pricing is substantiated within the offer document through a combination of quantitative and qualitative factors. The actual demand for the securities becomes known only after the issue has closed. For fixed-price offers, the level of oversubscription is sometimes quite high.
Book Building Issue
In this method, the IPO process itself drives price discovery. Instead of setting a single fixed price, companies define a ‘price band.’ The lower end of this range is called the ‘floor price,’ while the upper end is known as the ‘cap price.’ Investors then place bids for the number of shares they want at prices within this range. Based on these bids, the company decides the final share price and allocates shares at or above the floor price. Unlike the fixed-price method, this approach reveals demand on a daily basis throughout the book-building process.
The fixed-price method can undervalue a company’s shares during an IPO because companies often set the price below the actual market value. As a result, investors heavily oversubscribe these shares and later reassess the company more positively. In contrast, the book-building system improves efficiency by closely matching supply with demand without leaking information before final pricing. Since the company sets the final price only after closing the IPO, it secures a fairer return, while investors also benefit.
Analyse an IPO
When it comes to determining the price of a financial asset traded in the market, a fundamental law of economics applies: its value is determined by the forces of supply and demand. Newly issued shares are no exception to this rule; they are sold at the price that investors are willing to pay. The most astute analysts are experts in stock valuation, individuals who determine a stock’s intrinsic worth and, if the market price falls below their estimated value, capitalize on the opportunity to purchase those shares.
Initial Public Offerings (IPOs) represent a distinct category of shares, as they are newly issued. Companies launching an IPO have not yet been traded on an exchange and, compared to companies with an established trading history, have been subjected to less rigorous analysis. Opinions regarding the valuation and financing of IPOs vary widely. Some argue that the absence of historical price performance data presents a buying opportunity, while others contend that IPOs carry significantly higher risk than established stocks, precisely because the market has not yet fully analyzed or scrutinized them.
While various methods can be employed to analyse an IPO, the lack of a proven track record makes it difficult to evaluate these stocks using traditional analytical tools. It is crucial to investigate the company’s rationale for going public, its intended use of the raised capital, its growth prospects, and the quality of its management. Furthermore, a thorough review of the company’s Form S-1 filing is essential. Finally, to gain a meaningful context for valuation, the new IPO should be benchmarked against similar, established companies within the same industry.
How to Assess a New IPO for Your Investment Portfolio
If you maintain a good relationship with your broker, you may get access to oversubscribed IPOs before other clients. These new issues often see a sharp price rise as soon as they enter the market. Demand usually exceeds supply in such cases. As a result, the prices of oversubscribed IPOs keep rising. They continue to increase until demand and supply reach a balance.
Even if you do not get early access to new issues, you can still make a profit. However, this requires careful analysis of the companies issuing these securities.
The following are some key points to consider when analysing an IPO before making a purchase:
- Why has the company decided to go public?
- What level of profitability does the company expect to achieve?
- What is the company’s operational history, if any?
- How does the company intend to utilize the funds raised through the IPO?
- What is the quality of the management team? Do the key individuals possess prior experience in managing a publicly listed company? Is they have a track record of success in business ventures? Do they possess sufficient professional experience and qualifications to run the company? Does the management team hold any shares in the business themselves?
- What is the competitive landscape in the market for the company’s products or services? Where is the company’s standing within this environment?
- What are the company’s growth prospects?
You can find this information and much more; in the company’s ‘Form S-1.’ For any IPO analyst, reading this document is essential. After reviewing the S-1, the analyst develops a strong understanding of the company’s business model and operations. Using these insights, the analyst estimates a fair valuation for the company. By dividing this valuation by the total number of shares available for sale, the analyst arrives at a fair price per share.
Other valuation methods involve comparing the new share issue with similar companies already listed on the stock market; this allows one to determine whether the IPO price is fair.
Frequently Ask Questions
1. When can I expect my IPO shares to be credited to my Demat account?
The exact timeline may vary, as each company follows its own process. However, in most cases, investors receive their shares in the Demat account before the listing date. Once the shares are listed on the stock exchange, investors can start trading them.
2. Is there a difference between the ‘Floor Price’ and the ‘Cut-off Price’ in the ‘Book-Building’ method?
The ‘Floor Price’ refers to the minimum price at which bidders can place bids for shares using the ‘Book-Building’ method. Conversely, the ‘Cut-off Price’ refers to the final price at which the company allocates its shares and investors purchase them.
3. Is it mandatory for me to possess a PAN card to apply for an IPO?
You must have a PAN card to apply for an Initial Public Offering (IPO). Investors should enter their PAN details correctly in the application form to avoid rejection.
4. For how long does an IPO remain open for subscription?
According to Rule/Clause 8.8.1, the subscription list for a public offering must remain open for a minimum of three working days; furthermore, this period must not exceed ten working days.
5. Can I sell my IPO shares before they are listed on the stock exchange?
No, investors cannot sell their IPO shares before the stock is officially listed on the market. They must wait for the listing before they can trade the shares.
Conclusion
IPOs are unique because they lack historical trading data, meaning their valuation is based on the dynamics of supply and demand. It is crucial to understand why these companies have decided to go public and how they intend to utilize the funds raised. Evaluate key factors such as the company’s growth prospects, competitive landscape, and the quality of its management. To determine an appropriate valuation, review the company’s Form S-1 and compare the new issue against similar publicly traded companies.
Most importantly, remain cognizant of the high risks associated with IPOs, stemming from the lack of market scrutiny and trading history.
Disclaimer
This article is for educational purposes only and not financial advice. Stock market investments are subject to market risks. Please do your own research before trading.
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Mrunmay is a Data Analytics enthusiast with a background in Software Engineering and Machine Learning. He has completed professional training in SQL, Python, Data Analysis and ML and has worked on multiple data-driven projects. With a strong interest in stock market analysis and technical trading strategies, he focuses on simplifying complex market concepts into practical and easy-to-understand guides for traders.
Note: The information shared is for educational purposes only and not financial advice.