Last Updated on Sep 13, 2021 by Aradhana Gotur

2021 has been the year of IPOs. At the end of 8 mth of the calendar year 2021, 36 companies have hit the market with a total issue size of around Rs. 50,000 cr. The response from the investor community – retail, HNI, and institutional alike has been extraordinary. This has resulted in record over subscriptions resulting in listing gains that are double-digit or even triple-digit percentage in some cases. However, it is very important to also consider the fact that only 23% of the IPOs listed in 2007 have posted positive returns to date and 7% outperformed the broader Nifty50 index.

Well, what is an IPO?

An IPO – Initial Public Offering is a process when a company goes from private to public. It offers its shares at a value mutually arrived at by the company, its advisors, and bankers. These shares eventually get listed on stock exchanges and are available for everyone to invest and/or trade. The process of investing in an IPO is very simple. An investor needs to have a Demat and a trading account. They apply to the IPO via a bid placed through their broker. Only if you are lucky, will you get an allotment.

Important parameters to evaluate an IPO

Some of the very recent IPOs remind me of a quote by his holiness the Dalai Lama. He said, “Sometimes not getting what you want is a wonderful stroke of luck!”. A couple of recent IPOs were listed at a discount to their issue price. This shows that not every IPO makes money. Therefore, it is extremely important to understand and evaluate the companies in great detail. We at Piper Serica, give tremendous importance to the following 5 areas while evaluating IPOs.

Total Addressable Market (TAM)

This serves as the most important metric to understand a business and gauge its growth potential. The magnitude of the opportunity, the company’s penetration, and the ability to capture a large market will eventually decide its growth and shareholder returns.

Team

It is very important to critically evaluate the team that runs the company. We closely look at the background of the founders, promoters, and key people of the company. Experience of the team helps an investor decide how well would the company compete, grow, deal with problems, innovate and keep the customer as well as shareholder first approach intact. Along with the team, it is also important to evaluate the company’s culture. These parameters eventually feed into the company’s ability to attract talent, which is the biggest enabler of future growth.

Market share

Connected to TAM, knowing the company’s current market share and its strengths to capture a greater share is paramount. Here, in our thinking, it is better to go with the leaders than the challengers. A leader has already demonstrated its ability to acquire a higher market share while for a challenger, there is a high risk of slow growth, poor profitability, and the ability to invest in innovation to stay relevant. In case of new-age digitech companies that are coming up for listing, it is important to give credit to the founding team that has stayed together and has survived a high mortality rate that can be as high as 90% in case of start-ups.

Valuation

With scores of new-age internet companies getting listed, we have realized that there is a need to tweak some of the traditional valuation techniques that are proving inadequate to value these fast-growth companies. While we use the discounted cash flows, valuing companies with a very high terminal value, low cost of capital, volatile cash flows, dynamic capital allocation strategies and capital raising plans is challenging. Similarly, short-form valuation tools like P/E, PE/G and P/BV are handicapped because of low return on capital ratios for these high growth companies, long investment phase, and negative unit-level economics.

Therefore, one needs to have the long-term mindset of a private equity investor to value these companies. The valuation exercise is to estimate rather than establish a fair value. One needs to build in assumptions that reflect the large addressable market, the quality of the founding team that has survived high mortality, the ability to raise capital to support growth and most importantly, a leadership position in a very high growth industry.

Risks

While deciding which IPO should one invest in, knowing the risks that the industry and the company faces is as important as any of the above parameters. The company’s red herring prospectus (RHP) serves as a good tool since it lists all potential risks that it could face. However, the investor should also research various business, regulatory, technology and financial risks that the industry faces. Knowing the risks will eventually help the investors decide on the allocation of a particular company to the portfolio.

In the end, it is very important for an investor to understand that investing requires one very important psychological trait – patience. You might do all the hard work, research, analyse, apply and get an IPO allocation. But if you exit early just because of good listing gains, you give up on a potential multi-bagger. Let your stocks talk by their operating results – not by their daily or even yearly price quotations – whether the investment is successful.

The market may ignore business success for a while but eventually will confirm it. As Ben Graham said, “In the short run, the market is a voting machine but in the long run it is a weighing machine.” The speed at which the earnings grow is more important than the speed at which the price grows. In fact, delayed recognition can be an advantage: it may give a chance to buy more of a good thing at a bargain price.

Check out smallcases manged by Piper Serica, where the author is VP.

Ajay Modi
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