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Should You Invest In An IPO?

We received a bunch of questions from our readers during our recent “Ask A Foolish Question”, and one of them was (slightly edited for easier reading):

“How do I decide if an IPO stock is worth buying?”

So let’s roll up our sleeves and get started on answering this question.  Before we begin, an Initial Public Offering, often known as an “IPO” is the process of a private company listing and becoming a publicly traded and owned enterprise.

However man retail investors often see it as sure-win opportunities to “flip” stocks – that is to apply and sell it for higher profits in a few days or so.

Floated on Mainboard Exchange

IPO Date

IPO Price, S$

10 July 2013, S$

Change

Tee Land Limited (SGX: S9B)

6 June 2013

0.54

0.41

-24.1%

Asian Pay Television Trust (SGX: S7OU)

29 May 2013

0.97

0.855

-11.9%

Soilbuild Construction Group

27 May 2013

0.25

0.3

20.0%

Croesus Retail Trust

10 May 2013

0.93

0.95

2.2%

Mapletree Greater China Commercial Trust

7 May 2013

0.93

0.945

1.6%

Overseas Education Limited (SGX: RQ1)

7 Feb 2013

0.48

0.69

43.8%

Floated on Catalist Exchange

International Healthway Corp

8 July 2013

0.48

0.435

-9.4%

GDS Global Limited

19 Apr 2013

0.25

0.26

4.0%

Halcyon Agri Corporation (SGX: 5VJ)

1 Feb 2013

0.36

0.775

115.3%

Logistics Holdings Limited

18 Jan 2013

0.23

0.205

-10.9%

 

While IPOs may prove to be rewarding at times, they are not sure-wins and their performance varies based on various factors, including market sentiment. If you take a look at how the IPOs of 2013 have performed, it shows that Halcyon Agri Corporation (SGX: 5VJ) has stood out with more than 100% return but Tee Land Limited (SGX: S9B) fell way behind with a 24% loss as of 10th July 2013.

It is important to also note that IPOs have no prior background in showing their financial results except the prospectus. In addition, underwriters are usually conjuring up the hype on the IPO in an attempt to sell it at the best possible price – meaning that the IPO price may already be fully valued upon listing. Nevertheless, there will be people who are interested in taking a chance on finding a good IPO.

When deciding if you should undertake an IPO investment, one is likely only able to perform due diligence base on the information from the IPO prospectus. With that in mind, here are four points to keep in mind.

#1 Prospectus Summary

Before you invest in anything, you must understand the underlying company’s business and same goes for IPOs. As a rule of thumb, consider the types of products/services a company provides and invest in a business where you would buy those products yourself.

It is vital to know the use of the proceeds raised in the IPO too. The reason why companies opt to raise funds via a public listing boils down to two purposes: (i) to pare down debt OR (ii) to expand. More often than not, investors are more inclined towards companies which are seeking for growth as they offer better prospects ahead and potentially higher share price performance.

magnifying glass#2 Focus on the financial numbers

The information provided in the prospectus can highlight significant trends in the company’s financial condition and results of operations. In general, you can ask yourself the following questions similar to analyzing an annual report:

  • Is the company showing steady growth over the past years or a bumpy road prior to the IPO listing?
  • How many assets as compared to debt (financial position) does the company owns?
  • Look at the offering price – how much is the company valued at upon listing? What is the valuation metric used (Price-to-earnings or Price-to-book ratio)?
  • What is the dividend policy of the company?
  • Do the management team still own a substantial interest after listing? If yes, they will likely align their interests with the shareholders’ interests as well.

#3 Risk Factors

Many people tend to look at the upside but neglect the downside. The downside is just as important. Knowing the risk factors from the prospectus can give you a better knowledge of how the company will fare under various business/environment conditions.

Just recently, poor economic data from India led to a drastic fall in the Rupee. One of the stocks which generate income from India is Religare Health Trust (SGX: RF1U), RHT in short.

If you take a look under the “Risk Factors” section in its prospectus, you will be able to discern that significant fluctuations in the Indian Rupee and Singapore Dollar exchange rates will affect the NAV of the Units and the foreign currency value of the proceeds.

Risk factors are just like the small print you find in every promotion or document you sign; it is worth taking a look despite the additional time spent.

#4 External factors

If you have been investing in the markets for some time, you realise that companies tend to launch their IPOs only when the economy doing well. It is because IPOs tend to perform well when there is a positive market sentiment as people are more likely to take risks as compared to downturns.

Lastly, IPOs with prominent cornerstone investors (investors who take a big share of the offering and agreed not to sell before a certain period) give rise to utmost confidence for the retail investors. It is always heartening to know that there is a strong backing behind the IPO that you are going to invest in.

Foolish Bottom Line

I thank the reader who sent in this admirable question and hope that this article, while not exhaustive, will be useful for you. Even though IPOs are mostly deemed as speculative, risky investments, you can minimize the risks by understanding the operations of the company and where the company is heading in the future. Learning how to read a prospectus and other financial information such as Price-to-earnings ratio can be a good starting point.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.   Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.