Know all about IPO : Before you Plan to Invest

Written by Rakshita Bucha Jain 

Investing in an Initial Public Offering (IPO) is often seen as a gateway to exciting opportunities, especially in a dynamic market like India. The idea of buying shares of a company as it transitions from being privately held to publicly traded can seem like a golden chance to catch growth early.

 

However, before you dive into an IPO investment, there are several technical aspects to understand, all of which are crucial to making an informed decision.

 

What is an IPO

An IPO, at its core, is a company’s first step into the public stock market, offering shares to raise capital for expansion, debt repayment, or new ventures. Take, for instance, Zomato’s IPO in 2021. The company raised over ₹9,000 crores, with a clear goal of scaling its operations. While the allure of getting in early is strong, it’s essential to remember that not every IPO is bound for success, and the process is much more complex than it appears.

Draft Red Herring Prospectus (DRHP)

One of the most critical documents to examine is the Draft Red Herring Prospectus (DRHP), which every company must file with the Securities and Exchange Board of India (SEBI) before launching its IPO. This document is a detailed blueprint of the company’s operations, financial health, growth plans, and potential risks.

For example, Paytm’s DRHP, filed ahead of its much-anticipated IPO in 2021, revealed the company was not profitable at the time and may not be for a while. This was a huge red flag for some investors, and sure enough, Paytm’s shares struggled after listing, with prices dipping significantly. This illustrates the importance of understanding the DRHP thoroughly; it provides vital insights into the company’s financial health and can reveal potential pitfalls that may not be apparent from the brand's public image.

Pricing of Shares

The pricing of shares in an IPO can follow one of two methods in India- fixed pricing or book building. With fixed pricing, the company sets a specific price for each share, and investors know exactly how much they’re paying upfront. In contrast, with the book-building method, the company sets a price band, say between ₹100 and ₹120 per share, and investors bid within this range. The final price is determined by demand.

The book-building approach is often more flexible and reflects the market’s appetite for the stock. For example, when Sapphire Foods, a franchisee of KFC and Pizza Hut, went public in 2021, the price band was ₹1,120 to ₹1,180 per share, and the final issue price was at the higher end due to robust demand. While this suggests strong interest, it doesn’t necessarily translate into long-term success, another reason to tread carefully.

Allocation Process

Once you’ve understood the pricing, the next step is to navigate the allocation process. IPOs are often oversubscribed, especially popular ones like the LIC IPO in 2022. This means, the demand for shares exceeds the supply. Shares in an IPO are allocated across three main categories: Qualified Institutional Buyers (QIBs), Non-Institutional Investors (NIIs), and Retail Investors.

Retail investors usually apply for smaller lots, capped at ₹2 lakhs, and when the demand outstrips supply, a lottery system often decides who gets shares. While this may seem fair, it can also leave many retail investors without shares in a highly anticipated IPO.

Another technical, yet important, aspect of IPO investing is understanding the grey market premium (GMP), which reflects the unofficial price of the shares before they are officially listed on the stock exchange. In the grey market, shares of an IPO are traded at a premium or discount, offering a glimpse of how the market expects the stock to perform on listing day. For instance, the Nykaa IPO had a high GMP, indicating strong demand, and indeed, the stock debuted at a premium of over 80%. However, it’s crucial to note that the GMP is speculative, and while it can offer insights, it shouldn’t be the sole factor guiding your investment decision.

Lock-in Period

A lesser-known but vital aspect of IPO investing is the lock-in period. When a company goes public, there’s often a lock-in period for insiders, promoters, and institutional investors, typically around six months, during which they cannot sell their shares. Once this lock-in period ends, a large volume of shares can flood the market if insiders decide to cash out, which can drive down the share price. This happened with Burger King India after its IPO in 2020, where the stock experienced volatility after the lock-in period expired and some major investors sold their holdings.

Know These Too

It’s also important to distinguish between listing gains and long-term investment potential. Many retail investors buy into an IPO hoping to sell the shares for a quick profit on listing day, also known as listing gains. However, not all IPOs deliver immediate returns. For example, Coal India’s IPO in 2010 was hugely successful, with substantial listing gains for early investors. On the other hand, Paytm’s IPO was disappointing post-listing, with the stock struggling to maintain its initial price. The key takeaway here is that while listing gains are attractive, it’s essential to assess the company’s long-term prospects, including its business model, competitive position, and growth potential.

Finally, while SEBI regulates the IPO process in India, ensuring transparency and protecting investor interests, it’s essential to remember that SEBI’s approval is no guarantee of the company’s future success. SEBI ensures that all necessary information is disclosed, but it’s up to you, the investor, to dig into the details and make a well-informed decision. The risks involved in IPO investing are real, from stock price volatility to overvaluation and limited financial history, especially for new companies with little operational track record.

In conclusion, while investing in an IPO can offer exciting opportunities, it’s not a get-rich-quick scheme. Doing your homework is crucial. Study the company’s DRHP, understand the pricing mechanisms, keep an eye on market sentiment (including GMP), and evaluate the long-term prospects before making any decisions. IPOs in India, like Zomato, Nykaa, and Paytm, have shown both sides of the coin, there are no guarantees. Successful investing in IPOs requires a balanced approach where enthusiasm meets careful analysis, and only those armed with knowledge can truly make the most of these opportunities