Three ways to become a smart IPO investor

An IPO or initial public offering is when a private company sells its stock to the public for the first time. IPOs are common during booming markets such as the one we have now and there have been more than a 100 IPOs in India during 2007.

IPOs can make investors a lot of money because stocks are often underpriced (sold at a price less than their real value) which mean that they jump sharply on the very first day of trading and often continue moving upwards.

However as usual there is no free lunch and while IPOs often offer attractive returns they also carry additional risks compared to regular stocks. Here are some basic tips to make smart decisions when it comes to IPOs.

Understand the process

The process of pricing and auctioning an IPO is quite complicated compared to buying regular stocks and you should acquaint yourself with the details.

For example it's important to understand that many IPOs are oversubscribed. This means that investors demand far more shares than are being offered so that each investor only gets a fraction of the shares that s/he bids for.

For instance, though not always necessarily so, if an issue is oversubscribed 5 times and you bid for 50 shares you will end up with only 10 shares. You need to take this into account when you choose how many shares to bid for and also understand that until your excess money is refunded there is an opportunity cost in terms of the investments you are unable to make with that money.

The opportunity costs arises because the money invested remains with the company till the IPO process is completed and shares reach the demat account of investors. This takes about 20-25 days and hence your money remains locked for this period.

Occasionally, there are problems with allotment of shares and refunds and you should be aware of your rights and redressal options. The Securities and Exchange Board of India ( SEBI) is the main regulator of stock markets and they have excellent resources for investor education and redressal of investor grievances.

Be extra careful during a booming market

Booming stock markets like the one India is witnessing today tend to produce lots of IPOs as companies try to cash in on strong investor sentiment. This means that there may be more marginal, unknown companies offering their stock.

Careful analysis hence becomes all the more important. During such markets companies may also be inclined to demand unreasonably high prices for their stock making such IPOs relatively unattractive. Such problems occurred in the US during the dot com mania in the late 90s costing investors a lot of money.

Analysing an IPO

Analysing an IPO is similar to analysing other stocks but with a few differences. For example there will be relatively little financial information available and obviously no track record of the stock's previous price, dividends and so on.

While some companies going public have a long earnings track record, often they are relatively new companies without much of a history. In such a situation it becomes especially important to consider the reputation of the promoters and management running the company.

Some useful questions that investors need to ask themselves before putting in their hard-earned money: how experienced are the promoters in running businesses and the lead managers in handling an IPO?

Check out other companies that may be run by the promoters and if they are listed examine their market performance. Consider whether the promoters' previous business experience is relevant to the current company.

When the company is relatively new you need to understand its long-term growth prospects. Try to obtain estimates for growth rates and margins in the relevant industry and consider whether the company in question is likely to outperform its industry.

If the company belongs to a sunrise sector, say like biotech, try to understand at least a little of the underlying technology and its business potential.

Conventional valuations ratios like P/E can also be useful in figuring out whether the IPO is priced reasonably. However they are mainly relevant to companies with a reasonably long financial track-record.

For the most part you will have to rely on the issue prospectus for this information but try to diversify your sources by consulting financial publications and your broker.

Conclusion

IPOs are an attractive investment option, which sometimes provide stellar returns in a short period of time. However separating the stars from the duds requires careful analysis and some amount of risk-taking.