Investing in an IPO (Initial Public Offering) can be a rewarding opportunity, but it requires a thorough understanding of what you’re getting into. While IPOs often generate excitement, it’s important to approach them with a well-informed strategy. Some essential aspects to consider include evaluating the lead managers, analyzing pricing, and researching the promoters.
The purpose of sharing these tips and strategies is to help investors build a structured approach to IPO investing. Keep in mind that buying into an IPO is similar to purchasing shares on the secondary market, except that IPOs usually lack a historical performance track record. Since publicly available information may be limited, your analysis must rely heavily on the company’s red herring prospectus. To make informed decisions, consider these five core rules when evaluating any IPO.
5 Key Guidelines to Follow When Investing in an IPO
1. Fresh Issue vs. Offer for Sale (OFS)
Understand whether the IPO is a fresh issue or an offer for sale. A fresh issue raises new capital for the company and often supports growth plans. In contrast, an OFS is a route for existing investors—such as promoters, venture capitalists, or private equity funds—to exit. Be wary if the OFS involves a significant stake sale, as it could signal limited long-term commitment from early backers. Remember, unlike fresh issues, OFS does not change the share capital.
2. Evaluate the Company’s Track Record
Review the company’s financial history in detail. Don’t just glance at revenue and net profit—dig into profitability margins, return ratios, and operational efficiency over the last 3–5 years. Look for consistent performance rather than sporadic growth spurts. Stability and sustainability often matter more than high, one-time profits when it comes to long-term investments.
3. Assess Promoter Background and Credibility
The quality and integrity of the promoters can make or break an IPO. Reputed promoters with a history of transparency and sound corporate governance inspire greater investor confidence. Look for established business houses or entrepreneurs with proven expertise in their domain. Sound governance practices tend to reflect in better valuations over time.
4. Compare with Sector Averages
Validate the company’s financial projections against industry benchmarks. For example, if a specialty chemicals company expects 30% annual growth while the sector averages only 12%, investigate the basis of their optimism. Aggressive forecasts without strong backing can be a red flag. Always align expectations with realistic market trends.
5. Watch for Capital Structure and Dilution
Scrutinize the company’s post-issue shareholding pattern and overall capital structure. Excessive dilution through a large equity base can suppress earnings per share, which often weighs on valuations. Similarly, a high debt-to-equity ratio may expose the company to financial stress. A balanced structure is essential for long-term shareholder value.
3 Types of IPOs You Should Approach with Caution
While no investment is entirely risk-free, there are certain red flags that typically indicate a company may not be a suitable IPO bet. Use the following filters to stay on the safer side.
1. Legal and Compliance Concerns
Avoid companies facing numerous unresolved legal issues, large contingent liabilities, or pending environmental cases. Also be cautious if auditors have raised concerns or if there are consistent regulatory red flags. Such issues suggest poor compliance culture and pose significant risks for future operations and valuation.
2. Over-Diversified Business Models
Companies trying to do too much often lose focus. Historically, wealth-generating IPOs—like Avenue Supermarts or Shankara Building Products—have maintained a tight focus on their core businesses. A streamlined and specialized approach typically results in better margins, operational clarity, and long-term growth.
3. Questionable Use of IPO Proceeds
Always check how the company intends to use the IPO funds. Capital being deployed toward capacity expansion, technology upgrades, or product development is generally a positive sign. However, using proceeds to repay old loans or buy real estate may indicate poor financial planning or misaligned priorities.
