3 key things to keep in mind prior to subscribing to an IPO

While IPOs are an exciting moment for investors, we provide below 3 key things, for the sake of simplicity, you may want to consider prior to subscribing to shares during an IPO offer:

1. The Equity Story (i.e. why should you invest in the stock now)

   Put simply, the equity story of a company is a summary of the reasons why investors should consider subscribing to the shares of the company at the introductory price.

   For example, some companies may offer a long-term capital appreciation opportunity, i.e., investors believe that the shares will be worth more in the future and will therefore subscribe now to then sell higher in the next few years. Other companies may be focused on delivering an attractive and regular dividend yield to investors with limited potential for capital appreciation and will therefore mostly attract investors looking for regular income over capital gains. Most companies will provide a combination of regular dividends and long-term capital appreciation potential.

   Investors should therefore understand the equity story of the company to ensure it meets their investment goals.

2. Valuation (i.e. is the IPO introduction price attractive or expensive for new investors)

   The entry price for investors is a crucial factor in an IPO and will determine how much potential there is to make a capital appreciation in the future or how much risk one would be taking by subscribing to shares with a stretched introductory valuation. There is a psychological (and completely flawed) belief by some investors that a company’s price per share of MUR 50 is more expensive than a company’s price per share of MUR 10, for example. This is not always true and some of the more relevant metrics to consider in determining whether a stock is a good buy are usually:

   1. the price earnings ratio (PE Ratio) – one can look at the past PE Ratio or the forward PE Ratio (depending on the future ambitions a company, in which case the price earnings growth ratio [PEG ratio] could be more relevant).  The higher the PE ratio, the more expensive is the share price. To come back to our example above, a company with a price per share of MUR 50 and a PE Ratio of 8.0x would usually be considered cheaper than a company with a price per share of MUR 10 but having a PE Ratio of 35.0x;
   2. the price-to-book ratio – more relevant for asset-heavy companies, this ratio compares the market value of a company to its net asset value. Therefore, a price-to-book ratio exceeding 1 would tend to indicate that investors are paying a premium as compared to the company’s book value;
   3. debt-to-equity ratio – this measures the proportion of debt financing as compared to equity financing. A high debt-to-equity ratio poses a risk to a company if it doesn’t have the earnings or cash flow to meet its debt obligations. As with the other ratios, the debt-to-equity ratio can vary from industry to industry and a high debt-to-equity ratio doesn't necessarily mean the company is run poorly.
   4. free cash flow – this is an important metric in determining whether a company has sufficient cash, after funding operations and capital expenditures, to reward shareholders through dividends, for example.

    

3. Risks
   Even if there is usually a hype about IPOs, investors should not forget that any investment in stocks entail risks such as capital risk (risk of losing part or the entire capital, due to a bankruptcy, for example), market risk (risk of losses due to share price movements) and  liquidity risk (risk of not being able to sell the shares in an orderly manner on the stock market due to absence of buyers), to name a few. Prior to investing in shares, investors should always read the “Risk Factors” section in the Prospectus of an IPO to ensure they are aware and understand all the risks associated with investing in that company.

In summary, whilst some speculators tend to jump in on an IPO to make a quick gain on the first days of trading, one should understand that investing, as opposed to speculation, is a more disciplined approach and investors should have a horizon of at least 3-5 years when investing in stocks and should be ready to weather potential short-term volatilities as a result of changing market conditions. IPOs usually also provide the opportunity to diversify across companies, sectors and/or industries and it is crucial that investors understand and are convinced about the equity story, have a good understanding of the valuation of the company to avoid overpriced IPOs and invest according to their risk profile and tolerance whilst seeking to achieve their investment goals.

Share it