Initial Public Offerings (IPOs) explained in detail

Posted on by Finance Infopedia

IPO or Initial Public Offering is a buzzword that you will always hear if you are into equity investment.  Nowadays you can see the advertisements of IPO in televisions, magazines and especially on financial news channels. For example, below you can see the advertisement for ICICI Lombard General Insurance that came in the newspaper. So what exactly is IPO? Let’s learn this.

What is IPO or What is meant by Initial Public Offering?

IPO or Initial Public Offering is a process by which a private company issues their company shares to public for the first time. By issuing shares to public, a private company is converted to a public company. IPO enables public to participate in the growth of a listed company which is not possible if it is a private company.

For example, the following are the US private companies that are not listed in the US market because of which the public are not able to participate in the growth of these companies.

Below mentioned are some of the Indian companies which are not listed in India.

So by getting listed in the stock market, private company turn into a public company and give us the opportunity to invest.

How to find upcoming IPOs

As I mentioned in the introduction, you can see the advertisements of IPO in newspapers, televisions, magazines and especially on financial news channels.

You can use the links given below to find the list of upcoming IPOs in the US

To find the list of upcoming IPOs in India, you can use the links given below

Should you invest in IPO?

There is a common belief among investors that companies that do good business, in general, will grow their price in the very short term, hence they think that buying a company through IPO gives them the chance to buy at the lowest possible price and then sell at a higher price in a short period of time. This is one of the main reasons why everybody rushes to buy an IPO.

Still, there is a common question that arises in investor’s mind regularly and that is ” Is it a good idea to invest in every IPO?”

There is no doubt that investing in IPOs is a very good idea to create wealth. If you are investing in equity with a long time horizon, investing in IPO will give you a chance to participate in a company’s growth from the very first opportunity you received through companies IPO.

Just imaging the returns you would have received if you had invested in companies like Infosys, Bajaj Finance, Netle etc at the time they issued their IPO. Infosys issued there IPO in February 1993 and shares got listed on Indian stock exchanges on 14th June 1993. The issue price of Infosys was 95 and on the first day of listing in the stock market, Infosys started trading at a premium price of Rs. 145. Today, when I am writing this post on 3rd June 2021, one share of Infosys is trading at Rs. 1391. When I calculated the total CAGR of Infosys, after considering share splits, share bonus and all, from the IPO price to the price trading now, it turns out to more than 35% CAGR. Keep in mind that this return is without calculating the dividends. If you consider reinvesting all the dividends received, returns from Infosys will go up again.

Some invest in IPO with short term profit in mind. They buy IPOs considering the market mood and perception about a company and anticipate that the company will go up in a short period of time and try to make a profit from that. This is more of a gambling type of investment which I am not comfortable with.

Risk of investing in an IPO

Even though investing in IPO will make you look smart, it is not always a smart idea to invest in IPO without doing thorough research. There are occasions of making a loss by investing in IPOs. It is not by default that all IPOs will go up whether in a short term period or a long term period. Therefore, before investing in IPOs it is always prudent to analyse the company thoroughly before investing. The problem here is, like a listed company, it is not mandatory for the company to publicly disclose their annual report. Hence, for an investor, to invest in an IPO, it will be really difficult to get reliable data about the company. The only reliable source for an investor to invest in an IPO is red herring prospectus issued by the company. Make sure that you thoroughly go through the company’s red herring before investing in an IPO.

Click here to find the red herring document of IRTC

Where can I find the red herring prospectus of IPOs in India and US?

Red herring prospectus of new listing companies in India and US can be accessed from the links given below

  • Click here if you want to find the red herring of newly listed companies in India
  • In US, companies planning to go for IPO file their red herring filed by a company with the Securities and Exchange Commission (SEC). Here you can find the red herring of newly announced IPOs in US.

What is Red Herring Prospectus?

As I said earlier, for a listed company, the primary source of information for an investor is company’s annual reports. But in the case of a private company, issuing IPO for the first time, there won’t be any annual report shared with the public for the investors to understand the business model and financials of the company. Red herring is a document that solves this issue. Red herring contains all details about the IPO issuing company, its management, business model and also their financials which give information to an investor, which in turn helps an investor to make an informed decision to buy an IPO or not.

Click here to find the red herring prospectus of Barbeque Nations, an Indian company listed in BSE and NSE in the month of March’21.

What are the types of IPO?

There are mainly 2 types of IPOs. They are

  • Fixed price issue
  • Book building issue

Click here to read more about types of IPOs

How an Initial Public Offering (IPO) is priced?

We all come to know about IPO price once a company starts advertising about it in the media. But do you know who sets the IPO price? Do you know how IPO price is actually determined? If you ask this question to people investing in IPO, 99% will not be aware of it.

Even though there are different ways like DCF analysis to analyze the value of a listed company, it is very challenging to assess the valuation of an IPO based on its IPO price. Still, knowing how the price of IPO is set will give you a good perspective before investing in an IPO.

Below given are the steps for Initial Public Offering that every company should go through if a company wants to list their company on the stock exchange. To decide the price of IPO, we can divide the entire process into 3 stages.

Stage 1:

So the first challenge for the company is to decide on who will do the processing to file for IPO? The moment company management decides to go for IPO, they call their investment bankers or book running lead managers. It is these investment bankers or the book running lead managers who will do the required procedures and documentation to file the company IPO prospectus with SEBI. For that, they need to identify an investment banker and the best investment bankers can be selected based on the following criteria

  1. Reputation of the investment banker
  2. The quality of research done by the investment banker
  3. Distribution capabilities of the investment banker. See how much capable the investment banker is in giving advertisement and reach about the IPO to the to maximum institutional investors and public. This creates more demand for the IPO which could help the company to issue the share price in IPO at a better rate.
  4. Previous relations experience the company is having with the investment banker.
  5. Better relationship between the management of the company and the investment banker

Once the investment banker is decided, then it is the responsibility of the investment banker to verify the documents and come up with an IPO price range. The price of an IPO will not be a fixed number. Instead, it will be in a range like ‘530 to 550’ to ‘1020 to 1100’ etc. The price band is fixed by a process known as book building. Entire company financials, its management, the share price of listed peers in the same industry is reviewed by the investment banker and accordingly an appropriate price band is set.

Stage 2:

Once the price band is set by the investment banker, they take this company’s data and price band to some of the mutual fund companies and PE investors and build a book of demand and price. Based on the response received from these mutual fund companies they finalize the price range. Once the IPO price range is set, they will inform the public through advertisement and other sources about the price range.

Stage 3: How does a company offer IPO?

The company opens the IPO price range on a fixed day in the market, say for 3 days from 3rd June 2021 to 5th June 2021. As we know the price for the IPO is given in a range. The final price will be the result of the price range in which the mark applied for the price. Based on the demand for the IPO, price will move to an upper level or to a lower level of the price range. The final cut off price will be the price at which the public gets the IPO in the primary market. Once the public gets the IPO from the primary market through IPO, then on a later pre-fixed day, the company share will start trading in the secondary market like NSE or BSE. Here in the secondary market, price of the IPO will start moving up and down based on the demand and supply of the company’s share. If the demand for the share is more in the secondary market, are the price will go up from the IPO price and if the demand is less, the share price will go down.

Why does a company offer an IPO?

This question can be better answered if I explain it with an example that you can easily understand.

Let’s assume that you wanted to start a footwear manufacturing business in India. After doing thorough research you realized that the investment required to start a footwear manufacturing business in India is Rs. 1 Crore. Now the investable corpus you have with you is Rs. 50 Lakhs. So you need Rs. 50 Lakhs more to make it Rs. 1 crore. Like anyone else, you approached a renowned bank in your locality and submitted the business proposal and other required documents and you received Rs. 50 lakhs as loan from the bank. Now you have Rs. 1 Crore and you started your footwear manufacturing business.

After running your business for 3 years, you were able to successfully build your business empire. You have one plant and now to meet the growing demand, you need one more manufacturing plants at different locations. In 3 years time, all expenses have gone up due to inflation and now you need 2 crores to set up a new manufacturing unit in another state. Having an established business model, with better networks, you approached 2 potential investors and they agreed to join with you. They invested Rs. 1 crore each making it Rs. 2 crores sufficient enough to set up the new manufacturing unit.

Now, the entire investment amount in the footwear manufacturing business is Rs. 3 crores (Rs. 1 crore invested initially by you plus Rs. 1 crore invested by 2 investors each). As of now, there are 3 investors in the business with a total corpus of Rs. 3 crores, the first investor with Rs. 1 crore will have 33.33% share, the second and third investor with Rs. 1 crore each also will have 33.33% shares each.

So now with 3 investors with 33.33% each, the company continued to function with 2 manufacturing units. The company started growing more and in next 10 years company started moving to much higher levels. Now if the company wants to expand, they need 3 more advanced plants with more workforce. The corpus that the company needs to expand after 20 years is Rs. 1000 crores and for that getting investors is really tough. Here comes the value of IPO that turns a private company with 3 investors into a public company. By issuing shares of the company to the public, company can raise fund that can be invested in the business to grow the company’s business. By doing this promoter’s private ownership in the company will be lost, as more shareholders come into the business. But by keeping a major part of the share by promoters, they keep the decision making power in the business but also get more fund to invest in the business through IPO.

What is the requirement to issue an IPO?

SEBI has given clear eligibility norms for organization planning to go for IPO. They are below.

  1. In each preceding 3 years, a company should dhow a Net tangible asset of at least Rs. 3 crore out of which not more than 50% are held in monetary assets. The limit of 50% on monetary assets is not applicable in case the public offer is made entirely through ‘offer for sale’.
  2. In the last three years of the immediately preceding five years, a company should show a minimum of Rs. 15 crores as average pre-tax operating profit.
  3. Net worth in each of the preceding three full years should be at least Rs. 1 crore.
  4. If the name of the company is changed, at least 50% of the revenue for the preceding year should be from the new activity denoted by the new name
  5. The issue size should not exceed 5 times the pre-issue net worth

You can read more about this in this post

How to buy shares in an IPO? – Click here

What is the difference between primary market and secondary market?

In share market, there are basically two markets. The first one is primary market and the second one is secondary market.

Primary Market

Primary market is the spot where the company issues new shares to the public directly to raise capital. Primary market is also called New Issue Market (NIM) because as I said earlier, newly shares are issued to the public directly through primary market. All the IPOs comes through primary market. If you want to buy shares of an IPO, you should do it from the primary market. The money you pay for the shares go directly to the company hence it is called a primary market.

Primary market is used for IPOs, to issue preferential shares, for private placement, qualified institutional placement, rights and bonus issues.

Secondary market

Secondary market is the place where you and I buy and sell shares at a regular interval. All trading activities happen through secondary market. All the trading accounts you have of different brokerage firms are the platforms you use to buy and sell shares in a secondary market. In secondary market, even though you are buying shares of a company, you are not actually buying them from the company itself, instead you are buying these shares from another investor/trading or a mutual fund company. Secondary market or as I said the trading platforms like brokerage firms are just a mediator who helps a seller to meet the buyer at a matching price.