Are you interested in investing in an IPO?

7 April 2014 05:07 am

The Colombo Stock Exchange (CSE) witnessed an increase in Initial Public Offerings (IPOs) since the beginning of the year as a result of the incentives given by the budget for the year 2014 and the prudent measures taken by market stakeholders.

The current trend attracts many investors to the market. These investors will be able to maximize opportunities only if they make informed decisions. They should refrain from making unwise decisions as done in the past. Hence, this article will give out some useful tips when investing.



Seek — and secure — objective research
It’s not as easy as you might think to find good objective information or research on a private company on the cusp of going public, yet doing so is absolutely essential.
Start by scouring the web for information on the company — particularly any details regarding financing as well as past and current press releases. They can inform you of any news, research or analysis of your IPO, the anticipated price for the offering and perhaps even how the company’s major executives and shareholders have been buying and selling their stocks.

There are still other firms that specialize in performing in-depth IPO researching and reporting. They may charge a nominal fee for this extra information but ensuring you’re well-informed on your prospective IPO is often worth the extra expense. By performing good research, you’ll be able to determine whether your IPO is a stable company, or if it’s just being over-hyped.

It’s also a good idea to take a look at the health of the overall sector in which the company you’re interested in belongs to (e.g., manufacturing, information technology, health care, bank finance and insurance, hotels and travels, etc.). For example, if you’re considering an IPO in the manufacturing sector but that particular sector hasn’t been faring well, you may want to reconsider.




Read and understand the prospectus
For most people, thoroughly reading their investment prospectus can seem nothing more than a tedious — if not entirely soporific — endeavour they’d rather not undertake. Investing in stocks, however, and particularly investing in IPOs, requires that you do more than just skim the prospectus — you must read it from cover to cover. While the material may be a bit dry, the information contained within the prospectus such as the company’s opportunities/risks and how the funds the IPO raises are proposed to be used is invaluable.
Highlighted below are some of the sections of an IPO prospectus that an investor should consider. 

•  Legal proceedings disclose the significant litigation involving the company.
   
• Management’s discussion and analysis gives the management an opportunity to discuss in narrative form the management’s perspective on the company’s financial condition, changes in financial condition and results of operations. This narrative section should provide investors with information to help them understand how and why the company’s financial results have changed over the time period covered by the financial statements and factors that management thinks might affect the company’s future financial condition or operating results.
   
• Dilution illustrates the usually significant disparity between the price that investors are paying for shares in the company’s IPO to both the book value of such shares and the average price paid by the existing shareholders that include founders, officers and early investors.
   
• Use of proceeds specifies what the company plans to do with the money it raises in the offering.
   
• Prospectus summary briefly summarizes information that is disclosed in greater detail throughout the prospectus, including the company’s business, strategy, plans for using the funds raised in the IPO, financial condition and as well as the terms of the IPO itself.
   
• Risk factors identify risks that the company’s management feels could significantly impact the company’s business, operations or performance or an investment in the securities being offered.
   
• Dividend policy describes the company’s history of paying and possibly its plans to pay, dividends to shareholders.
   
• Selected financial data discloses certain key financial and other data in a summarized column format. The information and presentation can highlight significant trends in the company’s financial condition and results of operations.  Companies are generally required to disclose selected financial data for the past years. You should also study the projected accounting figures in the prospectus carefully. If the IPO’s future earnings projections look too good to be true, well, that just might be the case. This is perhaps one of the biggest red flags you should look for when performing your research.
   
• Business describes the company’s lines of business, its principal products or services and their markets, any significant suppliers and customers on whom the company’s business depends and its competitive landscape and principal methods of competition. This section may also provide information regarding the relative contribution to the company’s financial results from different significant lines of business or operations in foreign countries. 
   
• The management offers biographical information regarding the directors and executive officers of the company.

It’s also worth remembering that while most companies do their best to disclose everything about the IPO in their prospectuses and provide as much information as possible, all the data and information are written by the company, not a disinterested third party or group.



Watch out for lock-up period
Lock-up agreements are legally binding documents that prevent existing shareholders from selling any shares of stock for a specified period of time. The problem is, when lockups expire all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realize their profit. This excess supply can put severe downward pressure on the stock price.



Evaluate the offering price
The company and the investment bank make the decision on where to set the offering price. It is important to understand that the offering price is determined by a mix of market conditions, analysis and the company’s performance.  Competing interests affect the determination of the offering price.

From the perspective of the company offering its shares in the IPO, the higher the offering price, the more capital the company can raise.

Under-pricing an IPO creates a discount for the initial investors and increase the quantity of shares applied for. This in turn could once again generate more capital to the company. Under-pricing may also affect how much, if at all, the stock’s price rises on its first trading day. If there is a large increase, or ‘bump’, from the offering price during the initial trading, the underwriter’s client-investors may be satisfied because the value of their investment will have increased. However, the company may be unsatisfied in that case, as it might have been able to sell its shares at a higher initial offering price and thereby raise more capital.

All of the foregoing factor into the determination of the offering price.  Whether you have an opportunity to participate directly in an IPO or are buying shares in the open market, it is important to realize that the offering price reflects a negotiated estimate as to the value of the company. The offering price may bear little relationship to the trading price of the securities and it is not uncommon for the closing price of the shares shortly after the IPO to be well above or below the offering price.




Bottom line
Successful companies go public but it is difficult to sift through and find the investments with the most potential. Just keep in mind that when it comes to dealing with the IPO market an informed investor is likely to perform much better than one who is not.