How to Evaluate IPOs: Key Metrics for Smart Investing

Investing in IPOs can be exciting and intimidating in equal measure. Firms that go public seek to attract investors to buy the offered shares and substantially increase their capital inflow. But between the hype of a promising IPO and the realisation of long-term growth lies a minefield of risks. Knowing how to value an IPO can help investors make informed decisions, rather than impulsive ones.

Know What You Are Getting Yourself Into: The Basics of Investing in an IPO

An IPO is a way of companies issuing their shares to the public to raise capital. Investors can get in early on this investment stage and potentially earn big rewards as the company grows. For investment in an IPO, you would need a demat account. Most people prefer to open a demat account through an online broker or a web trading platform due to its convenience and easy accessibility. A mutual fund appmay also have the functionality to allow investment in IPOs.

Now, let’s look at how you can evaluate an IPO and invest smartly:

Company Financials

Revenue growth

First, look at the revenue growth over the past couple of years. Consistent revenue growth indicates confidence in the company’s products or services.

Net Profit Margin

A stable or increasing profit margin indicates that the company effectively controls its expenditures. A company not making a profit currently can still be a worthwhile investment if it demonstrates reasons for future profitability.

EBITDA and Operating Margins

Earnings before interest, taxes, depreciation, and amortisation (EBITDA) represent the core profitability of the business concerned. Generally, high operating margins relative to their competition indicate a competitive advantage.

Valuation Metrics: Determining the Right Price

Price-to-Earnings

This considers the relationship between a firm’s stock market price and earnings per share. Compare it with competitors within the same industry to see whether the IPO is sensibly priced or overpriced. A high P/E ratio may reflect overvaluation, while a low P/E is likely to indicate undervaluation.

Price-to-Sales Ratio

The P/S ratio helps the investor estimate whether one is overpaying for each rupee the company makes in revenue by dividing its market cap by the revenue. A lower P/S ratio usually indicates a better value.

Enterprise Value-to-EBITDA

EV/EBITDA presents a general outlook on valuations, considering debt and cash reserves.

Debt and Cash Flow: Indicators of Financial Health

Debt-to-Equity Ratio

Companies that show high levels of debt-to-equity ratio can be a red flag. It shows that the company relies on borrowed funds, which may spiral out of control if the cash flow weakens.

Cash Flow from Operations

Cash flow from operations represents the money the company derives from its core business. Consistently positive and increasing cash flow from operations would mean that it would continue its growth without depending on excessive external funding.

Market Potential and Competitive Position

Market Size and Growth

A company in a fast-growing industry would carry higher upside potential. Ascertain the market size with growth prospects for the market this company serves. For example, most tech IPOs are alluring because of the huge growth potential the digital markets may hold.

Competitive Advantage

This refers to the characteristics that distinguish the firm from any competition in the market and can include technology, patents, strong branding, or even customer loyalty. The stronger an enterprise is with market advantages, the stronger it will be in defending itself against competition and expanding without interruptions.

Management Team and Shareholder Structure

Management Team’s Track Record

The experience and skill of the leadership team combined with past successes will potentially affect the future. It is a good omen for an investor who wants to invest in the company when the executives have built successful companies in the past.

Shareholding Pattern

Find out the equity percentage that the management and early investors will retain post-IPO. If insiders hold a big portion of shares, it is generally a good indication of confidence in the growth of the firm. Also, when they are selling big portions, that might suggest lack of long-term commitment.

Lock-Up Period and IPO Expenses

Lock-up period

This is a period whereby the company insiders are not allowed to sell their shares. The time could be six months after the IPO has been listed. Some of the insiders might opt to sell their stocks at this point when it expires, lowering the temporary price. Look for it on your web trading platform.

Anticipated Public Issue Expenses and Utilisation of Proceeds

If the utilisation of proceeds is to repay debt or working capital, then it is a poor indication of strengthening the balance sheet. Expansion/ growth plans are an indication of higher prospects.

Market Sentiment and Investor Interest in the IPO

Market Sentiment

Consider the broader market environment and sentiment about IPOs. In a bull market, the IPOs would do better since people are enthusiastic about investing. In bear markets, things might be different since it is cautious out there.

Investor Demand

If demand is strong, the IPO oversubscribes, and often the stock “pops” on the day of listing. Conversely, excess demand not supported by fundamentals leads to the overvaluation of stocks. A web trading platform or a demat app will often give you indicators of IPO demand to help you determine market interest.

Conclusion

Investment in an IPO can bring high returns, but substantial research and evaluation are called for. Use the financial metrics discussed to get a broad overview of the performance and potential of the company. Be wary of hyped-up IPOs and avoid making investment decisions based on the recent market noise. Rather, focus on the fundamental factors of the company, growth prospects, and valuation metrics.

Open demat account with HDFC Sky and easily invest in IPOs. Blending these digital tools with a disciplined approach to IPO evaluation will enable you to make smarter and more value-based investment decisions rather than purely emotional ones.