It is common for companies to list on the sharemarket to raise capital required for future business plans. Given the recent Rs 7 billion-rupee float of People’s Leasing Company, it is an appropriate time to examine how an investor might analyse a float and determine a risk/reward relationship for such an investment.
An initial public offering (IPO) is the process by which a private company becomes publicly traded on a stock exchange. Once a company is public, it is owned by the shareholders who purchase the company's stock when it is put on the market.
First, irrespective of the reasons why a company floats, it is important to understand that all floats, in my view, are investments that require a significant understanding of the underlying investment and should be treated as such. Until someone is willng to part with their money it is difficult to assess the real price or demand for a company's shares. The mistake many people make is to become emotionally attached to the story being sold to them about the company. This is particularly likely if they use the company's products or services, or have received advice from someone they perceive to be credible.
For many investors, the only real exposure they have to the IPO process occurs a few weeks prior to the IPO, when media sources inform the public. How a company gets valued at a particular share price is relatively unknown, except to the investment bankers involved and those serious investors who are willing to pore over registration documents for a glimpse at the company's financials.
The first goal of an IPO is to sell the pre-determined number of shares being issued to the public at the best possible price. This means that very few IPOs come to market when the appetite for stocks is low - that is, when stocks are cheap. When equities are undervalued, the likelihood of an IPO getting priced at the high end of the range is very slim. So, before investing in any IPO, understand that investment bankers promote them during times when demand for stocks is favourable. When demand is strong and prices are high, there is a greater risk of an IPOs hype outstripping its fundamentals. This is great for the company raising capital, but not so good for the investors who are buying shares.
Like any sales effort, a successful sale hinges on the demand for the product you are selling - a strong demand for the company will lead to a higher IPO price. Strong demand does not mean the company is more valuable - rather, the company will have a higher valuation. In practice, this distinction is important. Two identical companies may have very different IPO valuations merely because of the timing of the IPO as compared to market demand.
Another aspect of IPO valuation is industry comparables. If the IPO candidate is in a field that already has comparable publicly traded companies, the IPO valuation may be linked to the valuation multiples being assigned to competitors. The rationale is that investors will be willing to pay a similar amount for a new company in the industry as they are currently paying for existing companies.
Some of the factors that play a large role in an IPO valuation are not based on numbers or financial projections. Qualitative elements that make up a company's story can be as powerful - or even more powerful - as the revenue projections and financials. Herein rests a harsh truth about IPOs; sometimes, the actual fundamentals of the business take a back seat to the marketability of the business. It is important for IPO investors to have a firm understanding of the facts and risks involved in the process, and not be distracted by a flashy back story.
When looking at valuing an IPO it is important to value it like you would any other company, consider the cash flows, balance sheet and profitability of the business in relation to the price paid for the company. Sure, future growth is an important component of value creation, but overpaying for that growth is an easy way to lose money in investing. In assessing a float, I suggest you move past the fancy pictures and marketing and head straight for the financials to form your own view about how realistic the forecasts are. Also read commentaries by experienced analysts and wealth managers who are not connected with the float in any way, and stay clear of analysts from brokerages that are involved, either through conducting the float or being given an allocation of shares to sell.
(The writer is Head of Private Wealth Management at ArpicoAtaraxia Asset Management. He could be reached atanuk@ataraxiacapitalpartners.com) |
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