IPO Investing Requires Due Diligence, Not Lottery Mentality

Synopsis

August saw twenty companies raise over twenty-one thousand crore rupees. Listing-day returns have significantly increased from a discount to a premium. Investors should not treat initial public offerings as lottery tickets. Thorough due diligence is essential to identify strong businesses and avoid duds. Analyzing financials, valuation, and offer details helps separate quality investments.

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August saw 20 companies raise more than ₹21,000 cr, the busiest month in a year. With marquee names like NSE, Reliance Jio and Zepto in the pipeline, supply of new listings should remain elevated. Average listing-day returns have gone from a 2% discount in January-March to a 7% gain in April-June, and a whopping 25% premium in July-August. Of the 22 companies that listed in the latest period, 18 delivered positive debut-day returns.

So, it's easy to start treating an IPO as a lottery ticket: subscribe, hope for a premium, and sell on listing day. At the risk of being a wet blanket, it's worth emphasising that listing gains are not a substitute for due diligence.

Strong listing gains can create a feedback loop - successful debuts attract more investors, which encourages more companies to come to market, and can make valuations increasingly aggressive. A rising tide also lifts mediocre businesses. Eventually, though, rationality prevails, and the market discovers which businesses deserve the premium and which don't. This can leave investors stuck with duds. So, how should an investor go about separating the wheat from the chaff?

Biz buzz: The first question should be: is this a good business? Does it have a durable competitive advantage in a growing industry? If the industry's prospects look iffy, even a market leader won't be able to make it. At the same time, a small fish in a growing, cut-throat industry will likely get eaten up.

Financials: Sustainable revenue growth is one piece of the puzzle. Growth should translate into operating leverage and cash flows. With new-age businesses increasingly up on the IPO block, profitability is no longer a given. But if operating leverage has been stacking up along with growth, one can at least make a bet on its path to profitability.

Cash flows are important to track, because they can help determine if the reported profits paint a true picture, or are on account of accounting shenanigans. Debt and working capital intensity also need a watchful eye.

Valuation: This is perhaps the most important filter in a hot IPO market. A great business can still be a bad investment if the price leaves little room for disappointment. So, it's critical to compare IPO valuation with listed peers on price-to-earnings, price-to-sales or other relevant metrics, but while adjusting for differences in growth and margins.

Take Bajaj Housing Finance IPO. Debuting during the market peak of Sep 2024, its issue price was already at a premium over the industry. Still, market frenzy led to the stock listing at over 100% premium. Since then, reality checks have caused an almost 50% loss to investors.

Another problem with valuations comes up in the absence of relevant peers. Like in the case of AI application business Fractal Analytics, sustained growth will have to set the benchmark for what constitutes a fair valuation, and that can take time.

Another question to ask is: what is the money for? How much of the issue is a fresh issue vs an offer for sale (OFS)? Fresh capital funding expansion or debt reduction can strengthen the balance sheet. An IPO dominated by an OFS means existing shareholders are monetising their holdings. An OFS deserves a closer look at the business prospects - if existing investors are selling, you need to be doubly sure of what you're getting into.

All in all, the offer document deserves more attention than the marketing pitch. Risk factors, related-party transactions, contingent liabilities, outstanding litigation, customer concentration, dependence on key suppliers and regulatory risks can tell a very different story from headline growth numbers.

Jio's proposed ₹37,700 cr issue comes with risks around regulations and capital intensity. NSE's IPO is entirely an OFS, making valuation and business prospects amid BSE's growing might, particularly important. Zepto offers a high-growth story but exposes investors to intense competition, and a business model still navigating the path to profitability.

In a market where everyone is looking for the next multibagger, one should ask: at this price, am I buying a good business, or am I simply buying into the excitement?

The writer is founder, Credibull Capital

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

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