IPO Investing Guide: Things to Know Before Investing in an IPO

The world of investing is vast, and one avenue that often intrigues new investors is the Initial Public Offering, or IPO. A lot of the retail investors lose money in IPO. They invest in an IPO for quick gains, but end up in losses because of higher valuation.

Out of the 31 IPOs that debuted in 2022, 25 have yielded positive outcomes for their subscribers. The IPOs in 2022 have, on average, provided a 32% return on investment up to this point, with four of those stocks increasing investor capital by more than two-fold over the course of the year.

Some of our new readers are are yet to make an investment, even for them, we will make things easy to understand so that you do not lose your money while investing in an IPO.

So what should you consider before taking the IPO plunge? Here’s a simplified guide to understanding IPOs and ensuring you make informed decisions. But first things first.

What is an IPO?

An Initial Public Offering (IPO) is a process where a company offers its shares to the public for the first time, aiming to raise capital. This is a crucial event for a company as it provides them with a platform to generate funds for various needs, such as business expansion, debt repayment, or other corporate endeavors.

Key IPO Terms to Understand

1. Red Herring Prospectus: A document detailing everything investors should know about the company, including its business strategy, management credentials, future plans, and more.
2. Price Band: The price range within which investors can bid for shares.
3. Lot size: The minimum number of shares you can bid for.
4. Underwriter: Professionals, often investment bankers, who manage the IPO process.

Things to Consider Before Investing in IPO

Research the Company: Dive into the Red Herring Prospectus.

The Red Herring Prospectus (RHP) is a preliminary document submitted by a company planning an IPO. It offers invaluable insights into the company’s operational and financial details. Going beyond a mere overview, the RHP reveals potential risks, management strategies, and the company’s vision. Familiarizing yourself with this document ensures you’re not just relying on market rumors or speculations.

Purpose of Funds: Understand why the company is raising funds.

Companies go public for various reasons, from debt repayment to business expansion. Understanding this purpose offers a glimpse into the company’s future plans. A company focused on growth or technology upgrades indicates proactive planning, while one constantly repaying debt might indicate underlying financial issues.

Company’s Business Model: Grasp what the company does.

A company’s business model defines its approach to creating and delivering value. Does the model seem sustainable in the long run? Is it adaptable to industry changes? If you’re unsure about the mechanics of how a company makes its money, investing in it might be a riskier proposition.

Management Quality: Look into the background of the company’s leadership.

Strong leadership can be the difference between a company’s success and failure. Investigate the track record of the top executives. Have they successfully led other ventures? Their past experiences, successes, and failures can offer insights into the company’s potential future trajectory.

Strengths and Weaknesses: Conduct a basic SWOT analysis.

Every company has strengths that make it unique and weaknesses that pose challenges. By conducting a SWOT analysis, you can identify not only these but also external opportunities and threats. This gives a holistic perspective, allowing for better decision-making.

Valuation: Ensure the company is priced right.

Valuation isn’t just about current worth but also potential growth. Is the IPO priced higher than its industry peers without justification? A company’s valuation should reflect its future earnings potential, and understanding this relation helps avoid overpaying for a stock.

Financial Health: Examine the company’s past financial performance.

Beyond just profits, delve into its debt levels, cash flows, and financial ratios. Companies with robust financial health are better equipped to weather economic downturns. A steady or growing financial track record often points to efficient management and a sustainable business model.

Peer Comparison: See how the company stacks up against competitors.

No company operates in isolation. By comparing it to its peers, you can gauge where it stands in terms of market share, innovation, and financial performance. This comparison can reveal if the company is a leader, a follower, or an outlier in its sector.

Market Potential: Consider the overall potential of the industry

Industries evolve over time. What’s profitable today might not be in a decade. Assess the future trajectory of the industry. Is it on the rise? Does the company have a strategy to address future challenges?

Avoid the Hype: Often, there’s a lot of buzz surrounding IPOs

Market sentiments can drive up IPO prices, leading to overvaluation. It’s crucial to differentiate between genuine investment potential and mere hype. Emotional investing, driven by FOMO, can lead to regrettable decisions. Always let research and analysis guide your choices.

By delving deeper into each of these areas, investors arm themselves with a comprehensive understanding, enabling better decision-making in the complex world of IPO investments.

Common Mistakes to Avoid Before Investing in any IPO

Overreliance on Grey Market Sentiments

The grey market is an unofficial platform where IPO shares are traded before their official listing on stock exchanges. While it can give a hint about the potential listing price, it’s driven by speculative sentiments and lacks regulatory oversight. Relying solely on the grey market can lead to a skewed perception of the actual value or potential of an IPO. Diversifying your research sources ensures a more rounded understanding.

Chasing Big Brands Blindly

A popular brand may have extensive visibility and consumer recognition, but that doesn’t always translate to a solid investment opportunity. Many big brands might have underlying operational or financial challenges that aren’t immediately apparent. It’s essential to look beyond the brand’s aura and assess its financials, leadership, and market positioning. A brand name alone shouldn’t be the primary driver of an investment decision.

For example, most of the investors  who invested in PayTM IPO and Zomato IPO did it because of their big brand names. Companies were listed at a higher valuation and hence, most of the investors are in red, even after one year of listing.

Ignoring Company Weaknesses

Every company, irrespective of its size or reputation, has weaknesses or potential vulnerabilities. Whether it’s operational challenges, high debt, or a volatile market presence, these weaknesses can impact the company’s performance. An informed investor takes a holistic view, weighing both strengths and weaknesses, to determine the potential risks and rewards of an investment. Ignoring these vulnerabilities can lead to unpleasant surprises down the line.

Borrowing to Invest in an IPO

Leveraging, or borrowing money to invest, amplifies both potential gains and potential losses. While the prospect of amplified returns can be tempting, it’s a double-edged sword, especially in the volatile world of IPOs. If the IPO underperforms or the market turns sour, investors can find themselves in a tight spot, struggling to repay their borrowed funds. It’s always safer to invest money that isn’t owed to someone else, ensuring personal financial stability.

Wrapping Up

Investing in IPOs can be alluring, especially when you hear stories of stocks soaring on their debut. However, it’s not devoid of risks. Being thorough in your research and understanding of the company can help you make informed decisions. Remember, every investment carries a risk, but a well-informed decision can mitigate that to a considerable extent. As with any investment, thorough research, understanding the process, and avoiding common pitfalls are the keys to making informed decisions. Happy investing!

Author: Sanjib SahaSanjib is a finance based writer who has a deep knowledge in stock market, cryptocurrency and mutual funds. He is also a co-founder of Financesrule.com

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