Your friends just mentioned about the latest sexy initial public offering (IPO) and said that you “can surely make money” from it. A part of you jumps up in excitement. However, before you get too excited and apply for the IPO, take a deep breath and read this article. You should learn more about a company’s business before investing and not depend on hearsay — this goes double for IPOs.
A company’s IPO prospectus (a thick tome containing around 500 pages) has all the information you need to know about the business. However, I don’t think anyone would have the time (or the patience) to read every word of an IPO prospectus.
This is why, in this article, we are laying out the main aspects to look out for in an IPO prospectus before you invest in one.
Understand the business
First and foremost, we have to understand what a soon-to-IPO company is about. To do this, you should look at how the company makes money, what its business segments are, the main investment highlights of the company, its future plans, and its industry prospects.
Most IPO prospectuses have the above information lined out in colourful pages at the start.
Next, we have to understand the total number of shares on offer. Most IPOs will have a public tranche that are offered to retail investors like you and me as well as a placement tranche. A placement tranche is only offered to certain investors such as institutional investors, banks, insurance companies, and wealthy individuals. Some IPOs do not have a public tranche at all.
We also need to know the IPO price — that is the price investors have to pay to subscribe for a share. The total number of shares in offer multiplied by the share price will give the gross amount of proceeds the IPO will raise.
The IPO prospectus will outline how the company plans to use these proceeds. The money is usually used to pay listing expenses, fund business expansion, and for general working capital.
The prospectus will also state the company’s dividend policy, which shows the percentage of earnings that the company wishes to pay as dividend. Some companies do not pay dividends, and this will be stated in the IPO prospectus too.
All businesses come with risks. The section on “Risk Factors” outlines the risks related to the industry and business, and risks associated with investing in the shares. All investors should note the risks involved before investing in any IPO.
Another thing to look out for is whether the company is reliant on a few key customers or suppliers to sustain its business. If so, it is a significant risk for the company as it could be in tatters if the relationship with any of the key customers or suppliers sours.
We should always invest in companies based on their business fundamentals. One thing to look out for is whether the company is making consistent revenue, net profit, and cash flow. It also not have too much debt, which could harm the company when an economic crisis strikes.
The first few pages of the IPO prospectus usually lays out the financial highlights such as the revenue and net profit trend in the most recent years. For a more in-depth look, you can turn to the income statement, balance sheet and cash flow statement (collectively known as financial statements) given in the later pages of the prospectus.
Warren Buffett once said that price is what you pay and value is what you get. The price of a stock tells us nothing about its value. IPOs are usually priced at overvalued prices to get the maximum returns for the key stakeholders of the soon-to-IPO company. Therefore, we should only invest in IPOs that are valued fairly at the most.
Usually, the valuation of the IPO will be under the section called “Offering Statistics”. Most of the valuation will be based on the pre-offering share count. Investors have to adjust the valuation for the post-offering share count to get a more accurate picture.
Management and key shareholders
On top of knowing what you are investing in, you should also know whom you are investing in. The management team of a company makes the day-to-day decisions of the business, and thus, they must be competent and have integrity.
We also want to know if management has significant skin in the game so that their interests may be better aligned with those of the company’s shareholders.
Knowing who the firm’s competitors are allows investors to size up the business’ competitive landscape. If the industry is too competitive and the company has razor-thin margins, it may mean that the company lacks competitive advantages.
Bonus: Independent market research report
An IPO prospectus typically contains independent market research reports on the company and its industry. These reports provide insightful information for investors who are looking to invest in the IPO as well as those who wish to gain more knowledge about the particular industry the IPO-company is operating in.
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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.