10 things to look for in the IPO prospectus before investing

IPOs as an asset class have given returns of 140% over the last 1 year and an equally incredible 57.6% since the beginning of 2022.

Jul 22, 2021 08:07 IST India Infoline News Service

We are in the midst of one of the biggest IPO-driven rallies in the market. With the success of Zomato IPO, other big-ticket IPOs like Nuvoco Vistas, Aadhar Housing Finance and Vijaya Diagnostics are likely to expedite their IPO plans. Even mega IPO issues like Paytm and LIC, slated in H2-FY22, are now moving on a war footing. Just, look at the BSE IPO Index below.
Data Source: BSE

IPOs as an asset class have given returns of 140% over the last 1 year and an equally incredible 57.6% since the beginning of 2022. However, this also puts the onus on the investors to read between the lines of the IPO prospectus. Investors often complain that the Red Herring Prospectus (RHP) contains limited information. However, one can still make the best of this information to take an informed view before investing in the IPO.

1. Evaluate the capital structure

Capital structure matters because this is the capital that the company has to service and that determines shareholder returns. Be wary of companies with a huge capital base as it needs big profits to generate even Rs.1 growth in EPS. Be wary if there are too many dilutive plug-ins like convertibles, preference shares, warrants to promoters etc.

2. Does the business model contain policy risk

This is true of most industries, especially sectors like manufacturing and banking. For example, you must be wary of an IPO where the entire success of the company depends on one or two government approvals. These issues can be extremely sticky, especially where the regulatory body has objections. In case of regulatory risks, it is best to stay off.

3. Does the business have competitive risks?

Competitive risk is inevitable in modern business, but lesser the competitive risk, the better. Prefer IPOs where the company is into a product line or service where it has a substantial market share or niche positioning. They can end up being value creators in the long run compared to run-off-the-mill commoditized businesses.

4. Basis for the offer price

This is an essential part of every red herring prospectus (RHP). The management, along with investment bankers, provides an explanation of the offer price. Often, the explanations tend to be prosaic and templated, but in case you find some unique claims in this explanation, it helps to double-check information and seek additional inputs.

5. Growth in top-line and bottom-line

This applies to most businesses when evaluating an IPO. Unlisted companies may have been profitable, but were never subjected to public scrutiny. One thing you can rely on is CAGR growth in revenues and profits. Normally, this is hard to misrepresent and, as a precautionary measure, you can do channel checks with industry associations to verify if the growth figures are credible.

6. Statement of indebtedness

Every RHP presents the statement of indebtedness of the company. This includes information on the short-term debt and the long-term debt. You can do some quick back-of-envelope calculations to get an idea of the interest coverage and DSCR before taking a call on such IPOs. One more thing you must look at is if any of the contingent liabilities can become a real liability in the near future. This information is available in the RHP.

7. Outstanding litigations and Auditor qualifications

It is normally hard to find companies in India who are not having some outstanding litigation. Routine litigations are fine but you must focus on the ones that appear grave and have disruptive potential. Also, auditor qualifications imply that the auditor has given the company an opportunity to rectify gaps in accounting, which the company has not done. As a potential IPO investor, litigations and auditor qualifications are red flags.

8. Equity dilution and fund utilization

Offer-for-sale is non-dilutive but the question is why do investors want to exit? In fresh issues, it is important to check how the funds are utilized. Raising funds for expansion, diversification are considered productively acceptable. However, raising IPO money for working capital or general corporate expenses is not a great idea.

9. Related party transactions

This appears in every RHP laying out the relationship between the company and promoters in terms of salaries, commissions, loans, business etc. Be wary of companies that have too many related-party transactions as they make the IPO story opaque. It is better to invest in IPOs that signal transparency.

10. Comparable valuations of the stock

This is the Holy Grail. You must always check the P/E of the IPO with industry P/E and peer group P/E. Look at other parameters like P/BV or EV/EBITDA just to reconfirm your view on the stock. Valuations are always subjective, but you are OK as long as it is not way off industry averages.

Now, all this may look tough and ponderous for IPO investing. But, remember, it is your money after all and you are always better off with a little extra effort and analysis before investing in the IPO.

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