Wednesday, July 20, 2005

IPO Analysis for Fun and Profit

Hi all! I’m back after a brief vacation and in keeping with my philosophy of writing for the thinking investor, here is my long-overdue note on IPO analysis.

[Note for people who think the title is nerdy: Make the profit and you’ll get my drift]

What follows is a list of things I look for when evaluating an IPO. These are, of course, generic and there are usually industry- and company-specific idiosyncrasies in each IPO that must be evaluated on a case-by-case basis.

The good news is that it doesn’t take too long to cover all the ground. On an average, it takes me no more than two or three hours to do the research (a fast internet connection is an asset) and make up my mind about an IPO.

Is that good enough? Possibly not, but then my track record is perhaps better than average and it’s tough to find more time than that anyway!

Part I: Screening (10 mins)

  • Already Listed: Beware if a company is already listed. Chances are that it is trading at a huge premium to the offer price band at the time of the IPO and you’re tempted to make easy money. Going by recent history in many such offers (Punjab National Bank, Jindal Polyfilms) the prices are likely to come down close to IPO levels and you’ll make little or no listing gains. Invest only if you really like the business and even then it might be a good idea to wait till after the IPO and pick up shares straight from the market.
  • Prior Experience: Experience of similar IPOs in the past should serve as a good guide to investing in any fresh issue
  • Industry: Are you comfortable with the industry the company is in or do you feel it has bleak / unpredictable / cyclical prospects over the long term. Know what you’re getting into
  • Market Cap Post Issue: Does the post-issue market cap ‘look’ reasonable or does it look like a grossly inflated figure e.g. Google has a market cap higher than McDonald’s, which, even given Google’s potential for stunning growth, seems a little out of whack
  • Demand: Check out the NSE-BSE demand graph on the NSE website, especially on the last day. This will indicate the extent of oversubscription. Most investors seeking to make quick profits would apply for highly oversubscribed issues but I tend to favour the less popular ones as chances of getting a decent allotment there are better.

Part II: Googling! (1 hour)

  • The Company Website: Look for their products and services, financials (if available), geographic spread, client list, history, management profiles, press releases, partnerships and client testimonials. If you’re really lucky, you’ll find downloadable documents / presentations related to the business and the industry on the company website. Read these carefully and no points for guessing that such transparency is a sign of good, professional management
  • News Items: Check out news items (try Google News) on the company, preferably going back at least 2-3 years. These will give you a feel about the company, its management and its overall direction as well as its recent achievements and level of visibility. One often also finds out things (usually bad things like lawsuits and squabbles between promoters) that are under-stated in the prospectus but quite important from an investor’s perspective.
  • Analyst Reports / Informed Opinions: Right from Sharekhan and Moneycontrol down to blogs like the celebrated one you're reading right now – there’s a wealth of opinion on the net. Get as many perspectives as you can.
  • Industry and Peer Group: Which other companies are engaged in similar lines of business? How are they doing? What are the general trends (growth, innovation) in the industry?
  • What People Are Saying: Check out the bulletin boards on Moneycontrol. They’re always buzzing with activity, though only about a tenth of the posts are of any use. You’ll might find a nugget or two there.

Part III: The Prospectus – Softer Aspects (30 mins)

You’ll find offer prospectuses (prospectii?) on the SEBI website. It could be filed as a draft, ‘red herring’ or final offer document. I have no clue as to the differences between these but I guess they are pretty much the same.

  • Risk Factors: These are outlined right at the beginning and again in the middle of the document. Several of these are of the ‘filler’ type but tread carefully – there might be a couple lurking about that could really rock the boat if they were to come about. Examples of these are sizeable lawsuits (ERA Constructions), chances of a major industry downturn in the near future, over-dependence on a single or small group of clients / suppliers etc. There is often a discussion of management’s viewpoint on some of the ghastlier ones and they are worth taking note of
  • Business Overview: There is usually a 2-3 page discussion of the industry structure and trends as well as key growth factors. This is worth reading to get an idea about the industry and to identify the company’s special niche (one hopes it has one!). As a bonus, knowledge gleaned from one prospectus can be used in IPO / stock analysis in the same or related industries
  • Objects of the Issue: The proceeds of the issue should be used entirely in value-enhancing, business-related purposes. Anything else – like Emami using 17% of the proceeds to build a plush head-office – is a strict no-no. Use of proceeds for working capital is also not a very encouraging sign
  • Track Record: The company must have a decent track record. Investing in brand-new companies (like YES Bank) is a huge risk in my book. If you must go for such issues thoroughly check out the management and the company’s strategy, because that is the sum total of what you’re paying for
  • Promoter and Management Profiles: Ideally the senior management should have long years of experience in the industry and be professionals unrelated to the promoters. Companies where the leadership roster reads like a family tree are best avoided
  • Promoter Holdings Post Issue: Should be high enough to keep them interested in the business but not so high as to smother professional management completely. Something like 40-60% sounds about right.

Part IV: The Prospectus – Financials and Hard Numbers (1 hour)

  • Check on Diluted Financials: Remember to check that all per-share data has been calculated on a diluted basis i.e. on the increased number of shares outstanding following the issue
  • Growth Rate: What is the cumulative growth rate of overall sales, net profit, and operating profit of the company over time (at least three years of data would be provided in the prospectus). What is the average year-on-year growth rate? Is it steady and increasing or showing signs of unpredictability, with wide deviations from the average growth rate?
  • PE Ratio: Is it reasonable compared to its peers (a peer-wise comparison is often provided in the prospectus)? Ideally the PE Ratio should be lower than the average growth rate and also at a discount to peer values
  • Return on Equity / Return on Net Worth: Is the ROE figure comparable or higher than its peers? Is it growing over time? I’d ideally like companies with ROE over 20% and growing
  • Debt / Equity Ratio and Interest Cover: Is the debt / equity ratio low (for the industry) and consistently falling over time? Does it compare favourably with its peers? Is the interest cover high (preferably over 5) and consistently rising?
  • Price to Book Value: To be a bargain, the price should be below the book value (price to book ratio of less than 1) but that is a utopian dream in a fresh issue. Anything that seems about right for the industry should be fine. Growth stocks (like IT, Pharma, Biotech) usually have prices waaaay beyond the book value.
  • EBITDA / Enterprise Value: This ratio determines the return on investment for someone acquiring or buying into the company (like us!) and works well for growth companies like small IT players and capital-intensive enterprises like airlines and telecom. I’d ideally look for something greater than 10%
  • Unusual Spurts and Dips in Financials: Look for suspiciously high profits in the last year or sudden increases in personnel / raw material costs. These may be genuine but one should know the reasons for the same.
  • Large Bonus Issues / Stock Grants in Recent Years: These only benefit the promoters and leave less on the table for investors like you and me
  • Notes to Accounts: Often neglected, this is the place to look for financial jugglery if you can make sense of it. If not, trust in God (and the management) not to hand you a mini Enron!

Part V: Informed Sources (10 mins)

  • Friends in the Company: Company employees are usually a good source of down-to-earth information that cuts through the hype. The flipside of course is that most insiders usually paint an overly pessimistic or optimistic picture based on a relatively narrow view
  • Industry Insiders: People in the industry usually have some idea of the main players and especially about their competitors. Such people are a good source of unbiased, though sketchy, information

Do write and let me know whether you found this useful.
Till next time, adios amigos!


Vibhu said...

I dont think I am going to spend almost 3 hours on analysing an IPO. I'd rather read your SWOT analysis and make up my mind. :)

Anil said...

I agree with vibhu.
I would rather use expertise of people like Investment Guru (Mr. Rajesh soni) who have a reputation of good analysis.
I would not like to reinvent the wheel.
You are also doing a good job

adarsh adarsh said...

In the similar vein as anil and vibhu here are some thoughts of mine regarding the kind of analysis you are doing.

Your analysis looks good on paper, but consider this, you beat the market when you bet on something nobody else does, buy low when nobody else would and sell high, the analysis you are doing is open in the sense there are thousands of investors and investing gurus and financial managers who are doing the number analysis, their tolerance levels might be different but system is the same (risk factors, p/e, debt, reputation, sales record blah blah blah. Hence you will never beat the market this way, and if it wernt for beating the market we might as well all but index funds and enjoy ourselves for those 3 hrs.
Amit what I would like to invest in is investing based on trends not many people notice, or investing in ideas or investing on a hypothesis, now thats where we might beat the market.

I am not saying it is a surer way to success, it is not breft of perils but it is something that differentiates a process from an idea, everybody can follow a process, infact we can build a calculator do do all that you are suggesting and there are many stock models that do just that, but we are but men of ideas and thats where we can beat other people.

I cannot take away the importance of what analysis you do, it is also important, but remember its a validation of a hypothesis not the hypothesis itself.

Anonymous said...

I think you can work better as a lecturer.

Amit said...

An interesting set of comments - and I particularly liked the last one on changing my profession! Glad at least someone besides me feels I should be paid for disseminating gyaan!

On a more serious note, I totally agree with Adarsh on investing in ideas / trends. After all that's where tomorrow's big winners will probably come from.

However, the role of research is in determining the correct price to pay for the stock once you've shortlisted it.

NO stock is so good that you can afford to pay ANY price for it (as was amply illustrated in the recent dotcom bust). Conversely almost any stock is good once it comes down to a particular price.

Regarding the professional money managers doing the number-crunching, remember that they manage large funds and are constrained to invest only in larger companies (typically over Rs. 5 billion in market cap). This applies even to the so-called midcap funds. There are thousands of companies that fall below their radar and this is the happy hunting ground for people like us as we can get in before the big guys. Most of tomorrow's big stories are also lurking around here.

Your views?

cvrk said...

Good article and good views! Even though underwriting has gone out of fashion on date, I would look at whether there are underwriters and their standing! Besides, If already listed one, i would see whether their present shareholding patterns, have mutual funds in them. I would certainly look at the promoters share after the issue!

Kim said...

Your analysis seems very thorough and it's great advice. I would also suggest to check out companies that aren't in the lime light. If you hear friends talking about a new product that they're all beaming about, check out those companies. When you've heard about the companies good fortunes through the media it's usually too late to make the big bucks. In the penny stock markets you can also find some good companies and a site that I like for advice is I hope this helps.

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