Why Chase IPOs When There Are Better Alternatives?

Share Market Weekly

If you are a stock investor you must have come across the term IPO several times. It's difficult to miss. Initial Public Offering (IPO) is the first step a corporation takes to raise fund from the public. IPOs are generally viewed with great optimism by investors. The moment any IPO offer is rolled out the stock brokerage firms start bombarding you with calls and emails explaining why you should apply for this IPO.

Why So Much Noise?

There is a reason why IPOs are launched with overwhelming fanfare. IPO is an opportunity for a company to go to public and raise funds. The maximum hype they create increases the possibility of the listing price going high. This is the reason all the stakeholders involved in the process i.e. promoters, underwriters, investment bankers go all out blowing the trumpet of the company and how it can become the big money spinner in the equity market. Phrases like 'Once in a lifetime opportunity' and 'success story' are frequently used to lure the gullible investors.

Some IPOs are floated by the promoters so the initial investors and the venture capitalists can cash out some of their stakes. A business, in order to stay afloat, raise funds from various sources. IPO is one such route. Always remember, before investing in IPOs ensure that the company you are investing in has robust business operations and has promising future prospects.

To understanding IPOs better let's take a look at some of the IPOs that were offered in 2017 and see how they fared post listing.

CL Educate

Offer Period - Mar 20, 2017 - Mar 22, 2017

Issue Price - Rs.500 - Rs.502 Per Equity Share

CL Educate commenced its business in 1996 by offering management test-preparation courses. They later broadened their business by launching Career Launcher brand under which coaching for medical, engineering and civil services is provided. The company also operates K-12 (kindergarten to 12th standard) Indus World schools, which offers vocational training while its publishing wing GK Publications provides publishing services.

Why It Underperformed?

The company was about to use funds raised through IPO for working capital requirement, pare debt and fund acquisitions. Compared to its peers the margins and ROE profile of CLEL do not appear to be attractive. The companys business is working capital intensive which coupled with expensive valuations did not stand in favour of the company. Also, there is lot more competition from unorganised players in the industry.

Music Broadcast

Offer Period - Mar 6, 2017 - Mar 8, 2017

Issue Price - Rs.324 - Rs.333 Per Equity Share

Music Broadcast Limited operates as a subsidiary of Jagran Prakashan Limited. It is a lead FM Radio broadcaster operates brands like Radio City, Radio Mantra across 37 Indian Cities.

Why It Underperformed?

Music Broadcast did not pay any tax in FY15 owing to accumulated losses. Since it will have to pay tax going forward, the net profit margin is expected to come down from FY16 which is seen in numbers as of now resulted in EPS of Rs.6.43. Total costs were expected to increase because of the new stations. This will result in margin contraction in FY17 before it inches up in FY19. Net growth would decelerate due to muted increase in EBITDA, higher depreciation/amortisation on account of license/ migration fee, incremental capex and finance cost. These factors have reflected on stock's performance.

Point To Note - Music Broadcast IPO was oversubscribed 39 times

S Chand and Company

Offer Period - Apr 26, 2017 - Apr 28, 2017

Issue Price - Rs.660 - Rs.670 Per Equity Share

S Chand is one of the foremost Indian educational content company that provides content, solutions and services across the education verticals in K-12 and higher education and early learning segments. It offers 53 consumer brands across knowledge products and services.

Why It Underperformed?

The seasonality nature of K-12 business affects operating revenue, cash flow and margins. It also caters to highly competitive and fragmented industry which can adversely affect if they are not competitive and efficient. Also, CBSE schools are asked to use NCERT books which may affect the business of the company. The company lacks in digital upgradation of the industry also its higher valuation makes it more expensive.

Point To Note - Despite weak prospects the S Chand IPO was oversubscribed 59 times

Mahindra Logistics

Offer Period - Oct 31, 2017 - Nov 2, 2017

Issue Price - Rs.425 - Rs.429 Per Equity Share

Mahindra Logistics is India's largest 3PL (third-party logistics) solutions provider. It follows an asset-light business model in which assets necessary for operations such as vehicles and warehouses are owned or provided by a large network of business partners.

Why It Underperformed?

Industry view was positive. Concern was company's performance and thin margin which results in higher valuation of the stock. Also, IPO was an Offer For Sale (OFS). So the company was not getting any capital through IPO to strengthen its business.

Point To Note - Mahindra Logistics IPO was oversubscribed 7 times

How Is An IPO Valued?

The price of an IPO is decided by supply and demand of the trade market. Usually, they are sold at the price at which the buyer would like to buy. Doesnt it sound too simple? In reality, the process of valuation isn't that easy. If an IPO is underpriced, then a chance of pocketing the gains after the listing is for a long period. On the other hand, if it is overpriced, post listing you wont get much gain. Any keen follower of latest IPO news would have clearly observed this in the performances

There are various methods of IPO valuation. The company which is going public hires an investment bank and an underwriter to do the valuation of the company. Their responsibility is to ensure that the price will perfectly complement the business at the same time will look attractive to the investors.

Absolute Valuation - When the company's basic value is measured against the market value using companys fundamentals it is called absolute valuation. Through this method, the per share value is ascertained.

Economic Value - Through this method, the value is determined by analyzing the companys residual income, assets, the risk appetite, debts to be paid off along with various such economic constituents.

Value of equity = Enterprise value + Value of cash and investments - Value of debt and other liabilities

Relative Valuation - In this method, the company is compared to the companies in the peer group that have the same business. This method is also referred to as comparable valuation.

Price To Earning Multiple - This is the most commonly used method to draw a company's valuation. The principle of this method is to compare companys market cap to its annual income. To ascertain the value of the company, its estimated equity value is divided by its current net income to find out the price-to-earnings multiple. Usually, this method is employed when the company has positive cash flow and when the companies in the same sector have similar capital and growth structure.

Other Factors Which Influence The Pre-IPO Valuation

  • The number of stocks being sold in an IPO offer

  • The organisational set-up of the private company

  • The current traded price of the stocks in the peer group

  • The growth potential of the company

  • Financial effectiveness of company's business model

  • The demand from the potential customers for company's stock

Reasons To Avoid IPOs

Mostly, IPOs are Overvalued

People believe an IPO is an opportunity to grab the good company at lower prices. The truth is that the IPOs are generally overpriced when they are offered. In fact, one of the biggest reasons for floating an IPO is that investors founders, venture capital firms who had invested in the earlier rounds of funding the business get an opportunity to fish out at least some portion of what they had invested.

That is also the reason why most IPOs are expensively priced. They are not valued to give you a piece of the business at a reasonable price, but most of the times it is an exercise to find investors who can relieve the existing investors.

Another important facet of IPOs is stakeholders involved in the process like investment bankers and brokerage firms. As an investor, you don't have to believe when they pitch an IPOs as "cheap and attractive". Their interest lies in fixing the IPO price (whatever the promoter wants) and then to justify the quoted price.

IPOs Don't Deliver What They Promise

You should always be aware of the fact that the investment bankers and underwriters of IPO are mere salesmen.

Once you come to terms with this fact you will look at the entire process rationally.

The entire IPO process is purposely hyped up to get as much attention as possible. As IPOs happen just once in each company, they try to get maximum mileage out the promotional drive. That is the reason IPOs are usually presented as "once in a lifetime" opportunity for the investors.

To justify the valuation promoters and investment bankers plant stories that will tactfully catch investors' fancy. Terms like "listing gains", "long-term story" and "bright future" are generously used. To understand the facts you have to scrutinize the IPO beyond its fancy claims. To put it in simple words, you need to get past the bright and glossy stuff that halos around IPOs and evaluate the offer on the basis of fundamentals. Investors are susceptible to fall for a scheme if there are too many people around they are buying it. This is called the Fear Of Missing Out or a FOMO effect. But always see to it that you don't buy a stock just because it's an IPO, do it only if it is a good investment.

Post Listing; Most Of The IPOs Underperform

The biggest attraction of any IPO is that it gives immediate upside at the time of listing. This phenomenon is called listing gains. It is true that many people who look for short-term gains in few weeks or months often get that. However, if you have a long-term investment perspective, the performance of most of the IPOs will disappoint you. Most of the IPOs underperform their peers, reason being - they started off with high valuations which their business did not justify in the secondary market.

Instead Of IPO - Consider This

As the IPO is the first stage of a company going public it is called primary market. In the primary market, you buy shares straight from the company. In the secondary market (the stock market) these shares are traded. If you are investing with a long-term view, it is always better to buy stocks from the secondary market when the frenzy of the IPO wears off and you get the chance to buy the stocks when they are available at discount.

Here are some of the stocks that we had recommended to our clients in the year 2017.


Company Entry Date Entry Price Exit Date Exit Price Gain/Loss Duration
Indiabulls Real Estate Ltd 03/20/17 82.5 04/19/17 129.55 37.92% 30 Days
GHCL Ltd 03/14/17 266.5 12/18/17 319.9 20.04% 279 Days
Banco Products (India) Ltd 02/21/17 201.5 05/05/17 247.35 22.75% 73 Days
Gujarat Alkalies and Chemicals Ltd 02/10/17 379 04/27/17 472.5 20.65% 76 Days
Sarda Energy and Minerals Ltd 02/09/17 249 07/24/17 307 23.29% 165 Days
Talwalkars Better Value Fitness Ltd 02/07/17 228.5 05/03/17 283.05 21.63% 85 Days
Tata Coffee Ltd 01/18/17 124 7/11/170 149.3 20.40% 174 Days
Lloyd Electric and Engineering Ltd. 01/10/17 270 02/17/17 337 22.36% 38 Days

Not All IPOs Are Overvalued Or Shall Be Avoided

In 2017, 38 IPOs were offered to the public. Out these 38 IPOs, most of the IPOs received an overwhelming response from investors and were oversubscribed many times. The idea of this article is not to dissuade you from applying for IPOs but to make you understand the importance of separating facts from fancy. A smart investor has to develop the ability to see through the claims of the promoters and understand the real value of the IPO issue.

Like there are overvalued IPOs there are also undervalued IPOs. Some of the IPOs like Avenue Supermarket, Dixon Technologies, Apex Frozen were offered at an attractive price. As these companies have robust business models and excellent financials they have performed exceptionally well and have multiplied their value manifolds. Always remember, don't succumb to the hype created by the promoters, make sure you check the fundamentals of the company before applying for an IPO.

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