IPO-Initial Public Offer – Should you invest in IPOs? Part-1

There has been a recent buzz in the air about the IPOs – infact, majority of the individuals start in the stock market by investing in an IPO and then later enter the secondary market trading. In this article, I aim to show some calculations and explain whether an investment in IPO subscription is really worth or can you look for better options.

Basically, the company, as long as it is privately owned, remains un-capitalized – meaning, it has a value, but it cannot get the benefit of that value. For e.g. you buy a house for 15 Lakh Rs and stay in it. After 5 years, the price of the house tripled, and reached 45 lakhs. You feel happy that your house is now worth triple the value. But can you capitalize on it OR can you benefit from the price rise? The answer is NO. You cannot sell the house because you are staying in it. So though you are having a good valuable house, you can’t unlock the value. The only thing you can do is feel happy about the value of the house or proudly tell your friends that now your house is triple in value. But unfortunately, there is no way to capitalize on this value increase, as long as you’re living in the house.

Similar thing goes for the companies – as long as they are owned by individuals or private partners, they cannot capitalize upon its value. So the best way is to sell a certain percentage of business to the public and get the money. The easiest way to do it is through an IPO.
For e.g. Wipro may decide to come up with an IPO. The chairman, Azim Premji, divide the company in 100 Million equal parts called shares. He decides to keep 85% of the shares with him and sell the remaining to the public through an IPO for a price, say 100 Rs. each share. So through IPO, he will sell 15 million shares at a price of Rs. 100 each and will be able to collect 1500 million Rs. So what he is doing is keeping the majority of the shares with him, so that he has full control of the company, and selling a small portion to the public for capitalizing the value of his business and get some money for further expansion or for entering in a new business segment. The portion of shares kept by Azim Premji ensures that he has full control over the company, and also makes him one of the richest men in the country. Please note that the nos. presented here are only for example, they are not the exact figures of Wipro.

The question is: Why would some good running business be interested in sharing his business profits with the public, if it is running smoothly and doing well.

Why does a company brings an IPO? When a company comes with an IPO and investors subscribe to it by applying for shares, they become partners in the business of that company. Why will a profitable business come out with an IPO and share the profits with millions of investors? The one and only reason for any company to come up with an IPO is that it needs money. Apart from that, there are no reasons for any business to come up with an IPO. The money that is required by the company can be for any valid reason – like
• expansion plans, for e.g. Andhra based Deccan Chronicle Newspaper brought its IPO with one of the reasons mentioned as expansion in Tamilnadu region
• paying off its loans/debts
• Investing into research and technology and purchasing latest equipments
• Entering into a new product segment (for. E.g. a floppy manufacturing company may need money to start manufacturing USB Pen drives)
• And several other similar valid reasons that appear to be utilizing money for better performance of business

Ultimately, it’s the investors who have to evaluate the business of the company and then take a decision about whether they should invest in this company or not. The reason for IPO: Requirement for money brings to a variety of options.

The company can take loans from the bank. But, the problem is that the company will have to pay a big interest each month. Also, they will have a commitment to repay the principle amount of the loan as well.
The company can also approach the private investors and ask for money, promising some partnership in their business. But such private investors are very less and it is difficult for companies to convince them and get money.

The simplest and the best way is to get money from the public through an IPO. The company will neither have to repay a monthly EMI or principle amount (like in case of loan from bank) nor will it have to convince the private investors and sell them a major portion of their business. That is the reason why companies choose to list themselves on the stock exchanges, by selling a portion of the company to the public.

Going further, I’m not going to tell you what should you look for before applying for an IPO or performance measurement metrices – but I’ll take an example of a company and explain how your investment in IPO works.

Let’s say there is XYZ Corporation coming up with an IPO with price band 90-100 Rs.. Remember, the markets are efficient and the market already knows about its valuations (as I’ve explained with the example of TCS IPO in my previous article Stock Picking: Good Company v/s Bad Company.) So the better an IPO is, the more it will get subscribed. For the example of Wipro above, 15 million shares are offered for sale to public. If you hear the news that the IPO was subscribed 5 times, that means there were applications worth 15 * 5 = 75 million shares. This usually happens when the market believes that IPO of the company is good. The mediocre companies will have mediocre subscription and the bad companies (as perceived by the markets) will have an undersubscribed IPO – meaning applications received were less as compared to no. of the shares offered for sale.

Continue to part II of this article