IPO-Initial Public Offer – Should you invest in IPOs? Part-2

This is Part-2 of the article “IPO-Initial Public Offer – Should you invest in IPOs?”. Please read the first part of the article before proceeding with this one.

Let’s carry on the discussion for an excellent company IPO, well perceived by the market. Suppose the IPO was subscribed 8 times, which is quite a mediocre figure for today’s IPO offerings. Retail investors like you and me can apply with a maximum of 1 Lakh Rs. Hence, you apply for 1000 shares at 100 Rs. each making it a total of 1 Lakh. You take this 1 Lakh money out of your bank and for the application time duration, it stays with the IPO company. Usually, by the time you get your money back, it is 2 months time.
Suppose you are one of the lucky ones to get shares allotment, you will get only 1000/8 = 125 shares as the IPO was subscribed 8 times. So you will get 125 shares at the price of 100 Rs. costing you a total of 12,500 Rs. The remaining 87,500 Rs. will be refunded to you. Suppose that on the listing date, the IPO had an excellent listing and the value increased 50% (from 100 to 150 Rs.) You decide to sell your shares and book profit. Compared to the allotment value of 12,500, you will get 18,750 from the sale meaning a clear cut 50% profit. You feel happy that you’ve made 50% profit. But is this the right way to calculate the profit?

The fact is that your calculations are based upon 12,500 Rs. Actually you’ve invested 1 Lakh Rs. for this entire investment. So your calculations should be based upon this 1 Lakh Rs. and not on 12,500. So on the 1 Lakh investment, you made a profit of (1875-12,500 =) 6250 Rs. net. On a percentage basis, this translates to 6.25% only (and NOT 50% as calculated incorrectly). However, the good thing is that this profit has come to you in a short span of time, 1 or a maximum of 2 months.

Now, lets look at your 1 Lakh Rs. that you invested. You take the money out of your bank account so you loose interest on it. For people who don’t know, the banks pay interest only on the MINIMUM amount of money in your bank account, between the 10th and last day of the month. For e.g., if I have 2 Rs. in my bank account of 10 July, and I put in another 1 Lakh on 11 July, I will get interest only on 2 Rs. because the minimum amount that I had between 10th and last day was only 2 Rs.
The entire process starting from IPO subscription application to getting the refund takes around 2 months. Even if it takes 1 month, the above mechanism by the banks to calculate interest ensures that you loose the interest for 2 months.

If you had kept them in the bank, you would have earned the 2 months interest. On 1 Lakh Rs. at an interest rate of 5.5%, this comes to approximately (1 Lakh * 5.5% % 2/12 months =) 920 Rs. approximately. On an investment of 1 Lakh, this is just 0.92% return.

Compare this to the return offered by the best performing IPO over the same 2 month period, the IPO with 6.25% returns figures better than the bank interest return of 0.92%. However, one thing to note here is that we are talking about the best performing IPO making a clear cut 50% hike on the day of listing as compared to the issue price.
Here is the list of uncertainties:
• There may be IPOs which may not be able to show a similar performance.
• There is uncertainty about the allocation of shares to you – the more subscribed an IPO is, the less chances you have for allocation.
• IF you end up applying for an IPO that goes in a loss on the very first day, then your investment is worse than what is there in the bank

In essence, the IPO business is not a one way straightforward route, where anyone can say apply for this IPO, and you are sure to get profits. There is always a tradeoff. Good IPOs will get more subscribed, the less chances you have for allotment and hence less profit on your investment. The mediocre IPOs will get mediocre subscription, so more no. of shares, but the price hike on the day of listing will not be substantial. For bad IPOs, you may get all the shares that you applied for, but there is no guarantee of making profits, sometimes you may even have to book a loss.
Let’s have a look at the probability-value calculations for our example of XYZ Corporation:
• Oversubscription: 8 times
• Your probability of allotment: 1/8 = 12.5%
• Your maximum return = 6.25%
• Net Value = 12.5% * 6.25% = 0.78% only.

For the money in the bank:
• Oversubscription: Not applicable
• Your probability of allotment: 1 = 100%
• Your maximum return = 0.92%
• Net Value = 100% * 0.92% = 0.92% only.

Now compare the two investments, you’ll find that money in the bank gives you better returns. However, mathematics and probability calculations work in its own ways; and it is completely subjective and left at the investor’s discretion to decide whether they should apply for IPOs or not. My point of view is that there is no big real benefit in applying for IPOs, even if they give as high as 50% returns compared to the issue price, because there is a cost and risk attached to it. You loose on the bank interest, and there is a risk of no allotment, or a risk of bad performance of the stock on listing. It’s just a matter of luck, if you end up getting good no. of shares in your IPO application and the stocks gets a fantastic opening on the day of listing. If you are willing to take the risk, take it – just remember that markets are efficient so everything that you see is already there in the subscription multiple and the listing price. You should look at applying through IPO if you really believe in the business of the company and hold on for long term.

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You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.