Things To Look For Before Investing In An IPO

Created on 11 Jan 2021

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Updated on 10 Sep 2022

Investment is one of the most important decisions for an individual that can help them achieve their financial goals. Making the right investment decision has the potential to increase individual wealth. And because of this, it so happens that people often end up making investment decisions without knowing the risks associated with that investment.

Suppose, a well-known private company wishes to expand and diversify its business, and this requires huge working capital. A lot of money would be required to raise fresh capital, and for this, private companies, instead of opting for bank loans, choose to offer a certain percentage of their shares to the public for the first time. This is known as the IPO (Initial Public Offering).

When a well-known company announces its IPO, it creates hype in the market which eventually attracts more and more investors to purchase. Sometimes, because of all the hype, peer recommendation, and expectation of higher returns, investors often invest into IPOs in a hurry, without even researching and analyzing the company. And this eventually leads the investor to face a huge financial loss.

So, what are the questions investors should be asking before investing in IPOs, and how can investors avoid potential risks?

Let's take a detailed look at things you should keep in mind before investing in IPOs.

What to look before investing in IPOs?

Investing in an IPO is an important decision, which should require a lot of analysis and prior research. 

Here are some key things to keep in mind before investing in IPOs:

Understand Your Financial Goals

Before investing in any company's Initial Public Offering (IPO), it is important to know your personal financial goals and risk tolerance. 

Whenever a company goes public, it creates lots of hype and publicity in the market in order to attract investors. Attracted by this publicity and/or on being recommended by people to purchase those shares, investors often end up investing into that IPO because of the fear of losing an opportunity.

However, instead of rushing through to invest in a hurry into any random IPO, you should do your own share of research. If you see future growth and potential in the company, then you should consider investing in its IPO. 

Understand the Business

Investment ideal Warren Buffet has become a successful investor by staying within his "circle of competence". He suggests "if an investor cannot figure out what a company is doing, it is highly likely that lots of other people are facing the same problem"; therefore, he suggests staying away from a company whose business activities are unclear to you as an investor.

It is a piece of integral advice and something important to keep a close eye on while investing. If you do not know anything about the business, then keep in mind that it's not you, it's them. 

Companies, in the prospectus, should mention what their product or service is and the problem that they are solving or any gap in the market that they are filling.

Once you know about the business, recognizing the new opportunity in the market is your next step. 

The magnitude of golden opportunity and the company's capacity to capture market share can make all the difference when it comes to growth and shareholder returns. Keep in mind that the largeness of the market is only an evaluation.

Research Well About the Company

When it comes to investing in a stock, conducting a deep and thorough research about the company you want to invest in and its business, is of utmost importance.

An investor should download the company's prospectus from its official website or from SEBI's official website to read it. If you are not able to understand any terms in the prospectus, instead of skipping that section, take help from someone who is an expert in this field.

The company's prospectus is important as it contains the information of its financial performance, the reason behind offering IPO, dividend policy, details of the promoters, details about the management, offer information, regulatory, and statutory disclosures, etc.

The prospectus is a basic beginning point for your research. But if you wish to go deeper, you can go through the media reports and follow the recent development of the company. Check for any default case on the company, any legal disputes that the company might have landed on, ongoing compliance, hasty managerial exits, etc. 

Once you're satisfied with your research, only then you should consider investing in the company's IPO.

These steps might be time taking and hectic, but they hold a lot of importance and should not be skipped, as they might give an exposure to the weak spot of the company and there are chances that you might discover something new from your research.

Understand the Risk

Investing in the stock market comes with a certain level of risk. Understanding the risk associated with the company is an important factor that should be taken into consideration.

The current market scenario, the number of competitors, and the quality of the products and services, and other such factors can help in understanding any potential risks associated with the company.

Many of these details can be availed from the company's prospectus.

Evaluating the Company's Management

It is important to take a look at the directors and managers of the company who play a major role in all its operations and functions. The company's management is somewhat responsible for driving it ahead. 

So, as an investor doing research, you should ask, "Do they (company's management) have prior knowledge and experience of the industry? For how long they have been working with the company? How well has the board of directors been functioning?"

One piece of negative news may be a misunderstanding, but several negative news and articles might be a hint to not invest in that company. 

Understanding the Utilizations of the Proceeds

As investors who will be investing their money in the company, it becomes important to note how the proceeds raised from the IPO will actually be used. 

If a company offers that only debt will be repaid, then it might not be an attractive choice to consider. If a company says that some proceeds will be used to partly pay the debt, some to open a new business, or some will be used for general corporate purposes, it suggests that money will be flowing in the business, which is a good sign for an investor.

Look at the Financials and Valuation

Financials are important factors in determining the long-term success of the business. Financials indicate how a company is utilizing its capital and also show the historical growth of the company. 

Valuation might be a tricky aspect for the retail investor; however, they should not ignore it. To start with, one should see how the valuation of the company fares as compared to the existing companies of the same industry. You can also employ techniques like price to book ratio, return on equity, and price to earnings to judge better.

Final Thoughts

Any investment be it in stocks, mutual funds or an IPO investment, depends on the financial goals and risk tolerance of the investor. A wise investor should not make their investment decisions based solely on the market hype, publicity, and peer recommendation of someone else. 

Investors should do their own share of research, and if they believe in the future growth and potential of the company in the long run, only then they should consider investing in IPOs. They should keep in mind that making the wrong decision will affect their financial wealth.

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Divyanshu Kumar

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Divyanshu did his post-graduation in Financial Economics, and that's when he realized that writing about finance interests him the most. He has been writing finance content for two years and considers himself a coherent and confident writer. As a Finance content writer, he reads a lot about the subject and makes sure he is up to date with the latest updates in the market. Besides that, he is passionate about fitness and works hard to maintain a healthy lifestyle.

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