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The 1 Thing You Need To Do Before Investing In an Initial Public Offering

Credit: Simon Cunningham

Let’s say a private company wants to expand but it does not have much capital to do so. It has three main ways to raise money. One is to knock on the doors of banks or ask its existing group of shareholders for cash. The third option, is to get the public to help.

When a private company goes to the public, it has only one way to do it and that is by offering shares through a process called an initial public offering, or IPO. Investors, in exchange for the money given to the company, would wind up as shareholders of the firm and can partake in the firm’s corporate growth (or decline).

The report card

But, how are investors to know if any particular private company going public would be a good firm to invest in? For that, investors can turn to its IPO prospectus. Reading the prospectus before putting our hard-earned money into a new company is the one thing every potential investor needs to do.

A prospectus is like a report card of the company – and it tells us many things. Here’s a list: What the firm is about; what its competitive advantages are; what kinds of business risks it faces; who’s managing the company; what are the firm’s plans for the cash raised through the IPO; and, what is the company’s historical financial performance like. That’s just a quick sample of the wealth of information which can be found in a prospectus. More importantly, the prospectus can also let you know a firm’s important valuation metrics (like its price-to-earnings ratio) at its listing price.

Looking at such information can give you a better idea on whether a particular company is worth investing in.

Some important flags

It might also be useful to point out some potential danger signs to look out for with an IPO. One such sign is that of a firm going public just to pare down its debt without having clear growth plans in place.

Another possible red flag could be a company with no or minimal operating cash flow. Companies that have problems producing cash flow from their business operations would have to continually raise cash either from their investors or take on debt – generally speaking, both aren’t ideal scenarios over the long-term.

A company paying high interest rates on its loans during a period when rates are low, like in today’s climate, might also warrant investors to take a harder look to make sure that everything is okay. Japfa Ltd (SGX: UD2), which just got listed this August, would be one example; the firm had total borrowings that amounted to around 25 times its net profit for 2013 and these borrowings had annual interest rates ranging from 2.35% to 16%.

Valuation

As an investor, we’d ideally want to buy shares which prove to be bargains. When it comes to an IPO though, chances are that they’re not a bargain. Why? Here’s billionaire investor Warren Buffett explaining the situation in the 2004 Berkshire Hathaway Annual Shareholders’ Meeting:

“An IPO is like a negotiated transaction – the seller chooses when to come public – and it’s unlikely to be a time that’s favorable to you. So, by scanning 100 IPOs, you’re way less likely to find anything interesting than scanning an average group of 100 stocks.

The seller of a $100,000 house in Omaha will never sell for $50,000. But if 100 entities each owned 1% of a basket of homes in Omaha, the price could be anywhere.

You’re way more likely to get incredible prices in an auction market.”

Spackman Entertainment Group Ltd (SGX: 40E), which went public just two months ago in July, would be a good example of a share coming to the market at an elevated valuation: It had a price-to-earnings (PE) ratio of around 27 when the general market, as represented by the Straits Times Index (SGX: ^STI), was selling for around 14 times its historical earnings.

Japfa is another one as it went public at a PE ratio of close to 23. IREIT Global (SGX: UD1U) joins the other two in the same category as its units was offered to the public last month at slightly more than its book value.

Foolish Question

A great friend of mine recently posted the following quip of his in a social media platform:

So I asked a friend, who’s an avid poker player: “Would you play in a poker tournament if you weren’t allowed to look at your cards?” He said, “Obviously no!” Then I asked, “Then why are you investing in an IPO without reading the prospectus?”

That’s some food for thought, isn’t it?

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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 Sudhan P doesn’t own shares in any companies mentioned.