Should You Invest in an IPO?

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You might have heard the term ‘a company going public’ either in the news or while researching investment avenues. When a private company makes its shares available on the stock market for the first time, it is said to be ‘going public’ (the market term). The first offer made to the public for buying shares of the company is known as the Initial Public Offering or IPO. If you are unaware of the IPO segment, then you can learn about it here and also understand how to buy IPO and the risks and benefits associated with it.

Understanding an IPO

The stock market can be divided into two broad segments:

  • Primary market
  • Secondary market

The primary market is the place where a company releases its shares directly to investors. This is where you can buy shares from the company. Once the shares are allotted, they can be traded on a stock exchange via the secondary market.

When a private limited company wants to issue shares, it has to comply with certain mandates laid by the regulatory authorities and convert into a public limited company. Based on the authorized share capital of the company, shares are issued. The first offering of shares is the Initial Public Offering. While a private limited company has few shareholders, in a public limited company, a large number of investors become shareholders. Once a company launches an IPO or an FPO  its name is listed on the stock exchange. If the company has been able to create hype and publicity around the issue, the share prices also see an increase. For instance, Tata Steel’s FPO launched in 2011, was 2.21 times subscribed on its closing day and Tata Steel Share prices increased thereafter.

There are three types of IPOs available in the Indian market:

  1. New offer – where the company is issuing shares for the first time ever
  2. Follow-on offer – where the company has already issued shares in the past but is looking to raise additional funds by selling more shares in the company
  3. Offer for sale – where existing promoters or major investors of the company sell a part of their shareholding via a public offering

Before investing in an IPO, it is important to understand the type of IPO to make an informed decision.

IPOs are also classified into two categories based on the price offering on the shares. These are:

  1. Fixed Price Offering – where the company fixes the issue price of the share
  2. Book Building Offering – where the company adopts a bidding process to determine the final share price

How to buy an IPO

Here is a quick look at the process of investing in an IPO:

  • Research – Every year, many companies launch an IPO (new offer, follow-on offer, or offer for sale). As an investor, it is important to research the company comprehensively before deciding to invest in it. Remember, a fundamentally strong company will grow and get you good returns on your investment.
  • Open relevant accounts – You will need a Demat account to receive the allotted shares and a trading account or sell them later if you wish.
  • Apply for shares in the IPO – You can apply for shares in the IPO via your bank account or the trading account.
  • Bid – If the IPO has opted for the book building offering, then you will need to bid for shares based on the lot size specified in the prospectus.
  • Receive allotment

Should you invest in an IPO?

Like any other investment avenue, there are risks associated with IPOs. On the other hand, the benefits of IPO to investors are many as well. Before you make a decision, it is important to understand the pros and cons of investing in an IPO apart from researching the company.

Benefits of an IPO to investors

An IPO is the issuance of shares by the company and offers the following benefits to investors:

  • In the case of new offer IPOs, investors get an opportunity to become shareholders of companies that have been successful and have turned public to raise funds for expansion or growth of the business. Hence, they can buy stocks of the company before it starts growing and receive good dividends/bonus shares as well as capital appreciation due to the increase in stock price.
  • When an investor purchases a share from the secondary market, the price of the share is determined by the demand-supply and the overall market sentiment. However, in the case of an IPO, the price is determined by the fundamentals of a company making it a good time to invest.
  • Usually, the share price during an IPO is reasonable making it possible for investors to purchase multiple shares of the company.
  • It is a good opportunity for investors to invest in companies that they believe to be market leaders of tomorrow. Many companies when venturing into upcoming sectors like clean energy etc also raise capital by means of an IPO. For instance, in 2009, JSW Energy launched an IPO to fuel their expansion plan. The publicity and success of the IPO later saw an increase in JSW steel share price and other industries of the JSW group as well. An IPO thus becomes a great opportunity to take a first mover advantage by investing in growing industries as well.

Risks of Investing in an IPO

While IPOs offer several benefits, there are certain risks of investing in IPO as well :-

Since IPOs offer an opportunity to earn good returns, many investors tend to invest in IPOs without researching the company. Not all IPOs are the same and while there some that gained around 100% within the first year of launch, others have lost 70-80% too.

  • SEBI has mandated every company to disclose some mandatory information to investors. However, these are dozens of pages of financial and company information that require time and financial knowledge to comprehend.
  • IPOs are usually hyped by the company to attract more investors. There is a risk of falling for the hype without conducting due diligence and investing in the wrong IPO.
  • The profitability of the investment is determined by many external variable factors.

The concept of equity investment is based on the idea of investing in a company that you believe in. If you have the time and the expertise to read through pages of company information and determine its fundamental strength, then you must consider investing in an IPO. Remember, IPOs carry risks. Hence, low-risk investors who usually tend to stay away from equity should probably stick with index funds and other low-risk avenues.

 Conclusion

Before making any investment decision, it is important to consider your financial goals, risk tolerance, and investment horizon. These are the three pillars of successful investing. Ensure that you consider the factors mentioned above and talk to your investment advisor before investing in an IPO.

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