IPO sweepstakes: The 9 red flags you need to look out for

Brooks Laboratories touched a high of Rs 131 almost immediately after listing on 5 September. Within 3 days - on 8 September - it came down to Rs 38.55. SRS Infrastructure reached a high of Rs 50 on the day of its listing, 25 January. Within 2 days - on 27 January - its market value almost halved when its price fell to Rs 27.

What’s going on? What earth-shattering change happened in the fundamentals of these companies within days of their listing on the stock exchange?

Nothing. But clearly, the gyrations suggest speculation in these scrips both before and after listing. And that’s no consolation if you invested in the IPO and forgot to sell at the listing high. Or bought the IPO at a high price, only to find that prices went lower on listing. You could have bought it cheaper if you had only waited.

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To help you navigate the rocky seas of the IPO market, we have compiled the things you need to keep in mind before investing:

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1. Valuation: IPOs are sometimes aggressively priced. This means you may get the same share cheaper after listing. One way to figure this out is to check for the fully diluted earnings per share (EPS). The prospectus will usually indicate this. The EPS should be calculated on net profits divided by the total shares outstanding after the IPO.

Let us look at the Paramount Print Packaging IPO that came out in April. Even at the lower end of its price band of Rs 32, it was priced at 51 times its earnings on a fully-diluted equity base. The packaging industry has around 60 players and even the best has the ratio pegged at around 12. So, if you find the valuation expensive, you can always wait for a better time to enter the stock if you are keen on it.

2. Rating agencies: While there is lot of dependence on what rating agencies have to say about an IPO, it’s not always that they call a spade a spade. With four major agencies in India, Crisil, Icra, Care and Fitch, and all of them running after the same pie of business, questions have been raised on their credibility. One should always look at their ratings with a pinch of salt as they are paid by the company to rate them. One should also differentiate between ratings on fundamentals and on valuations. Cheap valuations might not ensure good fundamentals and vice versa.

3. Latest quarter audited numbers and financial history: Companies have to go through a tedious process which sometimes takes even more than a year to get listed on the bourses. So, the numbers they report on earnings and profits in the prospectus might seem a bit outdated. You need to visit individual websites and try and look at the latest numbers to know whether the performance trend is the same or not.

Look at the financial history of the company 3-4 years before the listing. It could be that the company is suddenly showing you enormous profits for a couple of years before the IPO. Before that, the promoters could be showing losses or low profits. This gives you an indication of the governance standards with the promoter group. TD Power reported consistent net profit margins from fiscal year 2009. Contrast this with PG Electroplast whose operating margin for financial year 2010-11 was 7 percent while for previous years, it ranged between 3 percent and 5 percent.

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4. Private equity deals and price of promoters’ holding: Look closely at the price of shares issued to private equity firms or other parties before the IPO. For example, look at the Innovative Industries IPO. Before the IPO in April, the company gave shares away to a private equity fund of Standard Chartered at Rs 99.67 per share. Its issue price at Rs 120 was at more than a 20 percent premium to this price.

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Also, look at the cost of the shares held by the promoters to figure out the level of possible overpricing. Take the Brooks Labs IPO for an example. Two promoters held shares at an average cost of Rs 0.75 as they had given themselves bonus shares before the IPO. And they wanted you to pay Rs 90-100 for the same shares! Surely, the valuation needs questioning.

5. Utilisation of funds: The draft prospectus generally gives you a list of what the company wants to do with the money it collects from the IPO. More often than not, the company might not tell you in so many words, but would use your money to pay off its debts. That’s not the ideal thing to do as equity is a more expensive source of funds than debt. Moreover, your money does not create new assets and boost the company’s revenue in any way. So be wary if the company tells you it’s just going to build another new corporate office, or use it for general business purposes.

6. Role of merchant banker: The merchant banker involved in an IPO is crucial. Names like Kotak or Enam would be more reassuring as they would look at the fundamentals of the company before listing them. However small names would be likely to take up any business that comes their way.

7. Project evaluation: This, if mentioned in an IPO, also becomes important. Project evaluation, if done by the company itself, may carry some biases. But if independently valued, one could look at what the third party has to say. Also see if the bank is ready to give more loans to the company even after expanding its equity base through the IPO. Also look at the capacity that the company is utilising at present. Brooks was utilising only around 15 percent of one of its divisions, while for the other division it was 68 percent for four years!

8. Litigations: There is a separate section in the prospectus called Contingent liabilities which tells you about the litigation in which the company is involved and how much penalty it might have to pay if the cases go against them. Here one again needs to separate corporate litigation and criminal ones. Corporate litigation is more common with constant legal cases involving regulatory authorities. But be wary if the plausible penalty is big, given the size of the company. Look closely at criminal litigation, especially if it is against any promoter or significant official of the company.

9. Promoter track record: Look at past IPOs if any, of the same promoter group. Consider the SRS IPO in August this year. SRS Real Infrastructure Limited, of the same group, was listed in 1995 and has hardly seen any stock price movement. Sebi has rapped four promoters for malpractices in its initial public offering who were then banned for four years from accessing capital markets.