How would you analyse an IPO?

CEO of Lotus Knowlwealth, Ashok Kumar speaks on the fundamentals of
issue pricing and what makes IPOs such hot buys.

One hears the terms public issue, mutual funds, initial public
offerings, IPOs with frequent regularity. You want to be in the know
and make pots of money on the latest wave of financial products
hitting the market. CEO of Lotus Knowlwealth, Ashok Kumar speaks to
CNBC-TV18 on the fundamentals of issue pricing and what makes them
such hot buys.
Why does a company in the first place decide to come out with an IPO?
There could be various reasons. The most common reason is they need
funds. That is fairly logical. But there are companies that come out
with issues like the public sectors units, which are disinvesting,
where the government is disinvesting. You could have banks where they
are raising funds to enhance their capital adequacy. So the objectives
may be different but the fact is that they need funds for projects or
for a specific objective.
What could be the major 4-5 objectives? Why does a company need to do an IPO?
You would see that during a boom time, if you look very closely, you
might get a feeling that this company does not actually need to raise
funds. That brings us to the first point that when you look at an IPO,
you need to look very closely at the fact that, is the company raising
funds because it can do so in the market, or whether it is raising
funds because it needs to from the market? If the second is the case,
then you have a good IPO on hand. You could proceed to look at the
further nitty-gritty of the IPOs. Some other reasons could be
expansion, diversification, new projects, there could be a wide
variety of reasons but the important thing for an investor to do, is
to, sort of, do a due diligence on those.
What is the difference between public offering, PO, and IPO?
I think it's just a terminology mistake. An IPO means that the company
is hitting the market for the very first time, that's why the word
"Initial" is there.  Whereas the company like, lets hypothetically
talk of some of the banks, for example Dena Bank, which recently had a
public issue, it was not an IPO because it had already made it's
initial public offering sometimes back, this was it's subsequent
public offering.
What's the difference between fixed price IPO and book-built issue?

Typically you would have seen, if you look at the historical trend in
recent times, most of the banking IPOs have been fixed price IPOs. To
start with the distinction, a book-built IPO is one where a book is
opened and there are bids invited. There is a price range that is
indicated - a minimum price range and the upper-end of the price
range. So investors of all class, ie. you have the institutional
investors, you have the high networth investors and the retail
investors, all of whom bid for the issue at a price, that is,
somewhere between the lowest level, that's the lower band and the
upper band and depending on the number of applications received, the
maximum number of bids received at a specific price, the price settles
there. But in case of fixed price issue, it's somewhat of a no-brainer
because the issue price is fixed, it is offered to you, you could take
it or leave it. You needn't think of whether you should bid for a
higher figure or a lower figure.

Of all the IPOs that had happened in December, which method was
commonly  used - book-built or fixed price? Which would you prefer
personally?
I think the first book-built IPO was Hughes Software, if I am not
mistaken, I think it was way back in 1997. Thereafter, the trend has
been largely in favour of book-built IPOs. And internationally, the
trend is towards book-built IPOs. In the Indian context it's really
the banks that have thrived on fixed price IPOs. Now, why is that the
case? It really is the function of the audience that you are
addressing. If you are addressing an audience, that is predominantly
the retail investor base, fixed price IPO is what sells.
Whereas, if you are looking at the wider spectrum, you are looking at
institutional investors predominantly, you are looking at the high
networth investors, then indicate a minimum (value) and try and
extract more by having a book-built IPO, the trend very clearly is
towards book-built public offering.
In book-built, do you think there is a better price discovery
mechanism, in the sense that depending upon the demand and the number
of the bids that they have got, they will discover a price, does it
have more depth?
It would depend, there are always two sides to every story. For the
company, definitely it's a lot better. For the investor, especially
the retail investor, those retail investors who go by crowd mentality
and would want to bid simply because an institution bids at a certain
price, I think there is a trend, based on studies that we have done,
we have found that most retail investors bid at the cut-off price,
which means that whatever price that it settles at, you bid at that
price. So in that case the retail investor is not really doing his
homework and there is a possibility that if he gets the wrong end of
the stake, he could be badly hurt.
In that sense, when it's not a fixed price and it's book-built, you
have a cut-off price and you have the option to not bid for it in case
it's higher than you had estimated?
Yes absolutely. Say for example, you have estimated, lets assume a
price band of Rs 100-Rs 125 for a issue XYZ. Suppose your calculations
and the evaluations of the company indicate that a fair price is Rs
110, you go and bid Rs 110 and then find that the discovered price was
Rs 120, you are automatically eliminated from the allotment process,
which is fair enough. You are out of the allotment process because you
didn't expect or rather you won't be willing to pay Rs 120. But the
point I am trying to make is investors are using the easy option of
simply bidding at the cut-off price, which is fine in the market, that
is, (showing) a trend of moving upwards, but somewhere down the line
it could prove costly.
What are the disadvantages for a retail investor?
At the outset, I'm all for the book-built type of issues because
finally the retail investor have the same objective as an
institutional investor, that is, make money. So he should also be
prepared to lose money, just as the institutional investor does.
Having said that, I think the system that we follow in India is loaded
in favour of the institutional investors because whereas the retail
investor needs to make a full payment, say for example, if you were to
make a bid at Rs 100, in case of the IPO, where the price band is Rs
100- Rs 125. If you make a bid at Rs 100, say for 100 shares, you need
to make that full payment by cheque at the time you are making an
application, you can revise your bid three-times. But you need to make
a full payment at the time of making the bid. Whereas institutions can
go and bid for a huge number of shares and need to pay only
subsequently, there is no money that is put down. So that puts the
institutional investor at a very big, distinctive advantage over the
retail investor.
The issue is typically open for seven days. If you are not allotted,
how quickly can you expect the refund?
I think as a benchmark you could say 21 days. There are companies that
do it faster. There are companies that take a little longer. As a
benchmark, take around 21-days, which is how much time the entire
process and the conversion process takes, by which time the allotments
go out, the shares moves to the demat accounts, so you can take that
as a benchmark.
How would you analyse an IPO?
Typically you would look at the financial performance of the company,
not just for that year but for the past few years also. So what do you
need to do is, go back to the industry. You need to look at the growth
that is there in industry and look at the company, whether it fits
into a 'top performer' (category) in the industry and whether those
growth rates are justified. As a Chartered Accountant, I know for a
fact how easily figures can be manipulated. You can easily boost the
topline or bottomline, all within the law. So investors who take
figures at face-value, often find themselves coming to grief at a
subsequent date. So you need to breakdown those figures, rework on
them and then work the pricing out. You need to be sure that those
figures are real and not hyped up figures.
What is your experience when a company decides to do an IPO -  its
valuation vis-�-vis its listed peers? Is it expected to be a little
more expensive? How do you look at that?

Ideally, an IPO should be cheaper than that market peers. One of the
common mistakes that I personally feel, merchant bankers make is that,
they go and price the IPO as tightly as possible, typically what would
be the incentive for you and me as a retail investor to invest in a
IPO. If its fully priced as compared to its peers, you would rather go
for the known devil rather than an unknown devil. It needs to be
marginally underpriced, so that there is some icing left on the cake
when you are investing in that IPO. So, if we are talking of a P/E
multiple of 10 in an industry, it should ideally be around 7-8 so that
there is marginal upside left, even on the listed price.
Would you watch out for any ratio?
There would be an entire gamut of financial parameters to be looked
at. The debt-equity ratio is important. You would want to look at
whether the company will reel under interest burden subsequently. In
fact, there are companies that come out with IPOs to extinguish their
debt, which is a smart thing to do in certain cases. So in that case,
the interest burden goes away and the bottomline automatically
increases. Beyond that, the other ratios you would typically look at
are the operating profit margins and the gross margins. You could go
across the entire gamut of ratios.
What factors would you look at when you talk about qualitative factors?
I think the most important factor is the management factor. I think
when you interact with the management, when you look at the track
record of the management, you get a very good insight into what the
company is in and what it will be. Really the stock markets are all
about the future. If you go back from the management meeting, feeling
that you are not comfortable of what the promoters are saying or it's
not in sync with market realities, you probably closed your mind out
from that IPO. You often get that feeling when you talk to promoters,
especially when he is out of sync with market realities and pricing...