Features

What should investors know about IPOs?

17 Feb 2014 - {{hitsCtrl.values.hits}}

The year 2014 is expected to be a promising year for the Sri Lankan equity market. The All Share Price Index has witnessed a growth of nearly 5 percent within one month. Further on, analysts predict an increase in market activities especially in the primary market as a result of the expected increase in Initial Public Offerings (IPOs). Today’s article will address vital issues pertaining to investing in an IPO and the role of the regulator and the exchange.

The post-war experienced an IPO boom and certain investors invested without obtaining sufficient knowledge about the company. Some IPOs reaped short-term returns while others reaped long-term returns. Failing to understand this many expected unusual returns on the first day. The situation further aggravated when they invested in IPOs even when they did not go in line with their investment goals.

It is not always possible for the stock price to go up rapidly within the first few trading days. The mismatch between the performance of IPOs and investor expectations was unhealthy towards the growth of the primary market. Hence, the article will disseminate knowledge required in making wise investment decisions and thereby enable investors to maximize their profits.

Role of regulator and an exchange
It is disheartening to see how both new and seasoned investors at times fail to understand the role of a regulator and an exchange. Both parties have distinct roles within the market. Failing to understand these roles investors turned towards the aforesaid entities during the post-war IPO boom (irrespective of whether it fell under the purview of the regulator/exchange). The Securities and Exchange Commission of Sri Lanka (SEC) as a regulator plays a duel role of regulating the exchange of securities and developing the capital market, while the Colombo Stock Exchange (CSE) provides infrastructure for trade.

What is an IPO?
There are many ways in which a company could raise capital. One such method would be to offer company shares to the public at a pre-determined price. Companies offer shares to the public through IPOs. By doing so, a company goes from the status of private to public.

Who determines the price of a stock at an IPO?
A company that intends to raise capital for an upcoming investment could enter the market through an IPO. The price of a stock is of utmost importance for the company as it determines the total capital received. The amount of capital, type of stock (voting or nonvoting) and above all the issued price of a stock is determined by the company in consultation with the investment bank they work with. It does not fall under the purview of the regulator to intervene in deciding the price of a stock. It is not the practice even in developed capital markets.

How is the offering price determined?
In simple, the offering price is determined by a mix of market conditions and financial analysis. However, it is important to bear in mind that competing interests affect the determination of the offering price.

At the beginning, an investment bank and the company will decide the price based on one or more of the following standard methods.

Relative valuation multiples- This method is usually used to value young and high-growth companies with limited historical information. The company is valued on a multiple of the earnings per share generated or on enterprise value to earnings before interest, tax, depreciation and amortization.

Discounted cash flow valuations- This approach is usually used for mature companies that generate steady free cash flows.

Sum of parts valuation- This method is usually applied to companies that have distinct business segments with different outlooks for profitability and growth that need to be valued separately.

After the valuation process is completed the investment bank would approach potential key investors to get an indication on the price they are ready to pay. The final offer price is a midpoint of the offered price and asked price.

Are there any other factors considered when determining the stock price?
Even though financial analysis plays a pivotal role in determining stock prices many other factors could influence the price that at times would be contrariety to financial analysis. A company may command a higher valuation if they expect a positive and drastic change in the outlook of the company/industry which would increase company profits, revenue and earnings.

Market sentiments at the point of entering the market might also influence the offered price. The same company might set a higher price during a growing market and a lesser price when the market is experiencing a downward trend.

Another aspect of IPO valuation is industry comparables. If the IPO candidate is in a field that already has comparable publicly traded companies, the IPO valuation may be linked to the valuation multiples being assigned to competitors.

Why does not the regulator intervene in determining the price of a stock?
The key aim of regulation is to create a ‘conducive environment required for the efficient functioning of financial markets’. They create a conducive market and allow market forces to determine prices. If the regulator intervenes in the pricing mechanism in an unwanted manner it will not reflect the true value of the stock and result in price distortions. This could lead to inefficient markets.

What should investors know about the issued price?
The amount of capital raised is determined by the price of a stock. If there is a higher price the capital will increase while the capital might reduce if they put down the issued price. On the contrary, if the issued price is too high, the demand will be less pushing down the capital. Hence, the issued price can be a tradeoff between the two. Thus, it is important for investors to be vigilant when investing in an IPO.

How do investors decide on an IPO?
Decision to invest in an IPO should be based on solid reasoning. It was disheartening to see how certain investors bought shares through IPOs during the post-war IPO boom without sufficient research on the company. Solid reasoning requires sufficient information on the company which could be obtained by reading the prospectus issued by the company.

(To be continued next week)

Features

What should investors know about IPOs?

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