An Initial Public Offering (IPO) is when a company issues shares to the general public for the first time. By doing so, a private company becomes a public limited company. Its shares get listed on the stock exchange after the IPO. The idea is to raise funds from the market and have more cash in hand. The money, then, can be used to fund its projects, expansion plans or improve the existing infrastructure.
IPOs are issued in the primary markets. This is where new securities are issued directly to investors. On the other hand, secondary market deals with the trading of securities that were already issued in the primary market.
An IPO of a good company can usually guarantee you great returns. However, it does come with its own share of risks that you must be aware of. Here are some dos and don’ts for investing in IPOs:
- Check the valuation of the IPO and the ratings assigned to the company. Every company floating an IPO is graded by SEBI-registered credit rating agencies. The grade is assigned after assessing the company’s financial health and market conditions in comparison to other listed companies. It is issued on a five-point scale; higher the score, stronger is the company.
- Keep track of the underwriters involved in the IPO process. Also, try to select a company that is backed by a strong underwriter. An underwriter is an investment bank, or a group of banks that are hired by the company to handle the IPO. The underwriter purchases a part or whole of the new issue before the IPO. They, then, try to resell the stock to the investors at a price close to the IPO price. It, thus, acts as an intermediary between the company and investors. Moreover, if the IPO is undersubscribed, the underwriter buys the balance shares.
- Research the company properly before purchasing its IPO. Make it a point to read the company’s draft prospectus and risk factors. The prospectus, which you can access from SEBI's web site, provides information about the company’s financials, promoters, tentative issue price and so on. Since IPOs are floated by a private company, not much data would be available in public domain. So, a prospectus can come handy here.
- You can wait for the lock-up period of an IPO to end before subscribing to it. A lock-up period is a legal contract between the underwriters and company insiders that restricts them from selling their stock. The period ranges from three to 24 months. Once the period ends, both the parties can sell their shares. It can lead to a sharp drop in the stock’s value. This can be an ideal time to the buy the stock. The thumb rule in investing is: Buy low, Sell high.
- Do not buy an IPO just because of media frenzy or a good word of mouth. Opt for a company with strong fundamentals.
- Do not fall prey to discounts that some IPOs offer. Remain skeptical and make an informed decision. Discounts should be treated as add-ons only.
- Do not blindly buy government-sponsored IPOs. Opt for them when the overall macro-economic conditions are strong. You will get a value for your money.