IPO Investing Guide: Things to Check Before Applying for an IPO

An IPO can be thrilling.

You see a hot new IPO, read articles about it, and suddenly everyone seems to be talking about applying for it. Should you apply for the IPO?

An IPO is not always a good buy.

Before you apply for any IPO, it’s important to know more than just the “going public” story. Investors must evaluate a company’s business model, financials, valuation, promoters, and risks before applying for any IPO.

This IPO investing guide will share what things to consider before investing in initial public offerings.

What Is an IPO?

An Initial Public Offering (IPO) is the process of taking a previously private company public and making its shares available for public trading.

An IPO gives investors a chance to buy shares in a company before or shortly after its shares start trading.

However, an IPO does not guarantee gains. The listing price can be lower, higher, or around the issue price.

It is important to research things before buying IPO shares.

1. Study the DRHP or RHP

Draft Red Herring Prospectus (DRHP) or Red Herring Prospectus (RHP) is one of the most important IPO-related documents that every investor must study before buying IPO shares.

This document contains crucial details about the company’s business model, industry, promoters and management, financial performance, use of proceeds, and more.

You do not need to read each detail as if you are an investment banker. However, understanding the company’s business model, financial performance, risks, and purpose of issuing an IPO is essential before applying.

2. Learn About the Company’s Business Model

Before you buy any IPO shares, you must ask yourself: Do I understand the business?

Make sure you understand what the company does, whom it serves, its industry, competitive position, and growth drivers.

A company with a thriving industry is not necessarily a good buy. You must understand whether the firm has advantages that help it sustain its competitive position.

3. Evaluate the Financial Performance

Do not get lured by projections. Instead, take a close look at the company’s past financial performance.

Review revenue and profit growth, profit margins, earnings per share (EPS), Return on Equity (ROE), Return on Capital Employed (ROCE), debt, and cash flow.

Ideally, you want to invest in a company that has healthy cash flows and growing profits.

However, a rising revenue with low or no profits is also something to think about.

4. Value the Company

This is one of the most important aspects of IPO investing that many people miss.

Even the best companies can turn out to be expensive purchases.

Make sure to review the IPO valuation and compare it to companies in the same industry.

Common financial ratios to use include Price-to-Earnings (P/E), Price-to-Sales, and others relevant to the industry in which the firm operates.

Ask yourself: Am I paying a reasonable price for the company’s future growth?

5. Review the Promoters and Management

The promoters and management team play a crucial role in a company’s performance.

Therefore, it is important to understand who they are, what their stake in the firm is, any controversies surrounding them, and their track record.

Review the details in the prospectus to learn more about promoters and management.

Furthermore, make sure to note whether promoters are selling their shares in the IPO. At the same time, review the use of proceeds to find out whether the company needs more funding.

6. Know the Use of Proceeds

It is not enough to simply know what a company is worth. You must also understand how it intends to use the money raised from the IPO.

The proceeds can give you a good idea of what the company is worth and its growth trajectory.

Some companies use IPO proceeds to fund business development activities, including new facilities or product development.

On the other hand, some promoters may use the money for personal gain.

Make sure you thoroughly review the prospectus to understand how the company will use IPO funds.

7. Consider the Risks Involved

Every company carries some investment risks.

However, a company’s offer prospectus will highlight the unique risks associated with that particular business.

The risks could relate to competition, debt, regulation, customers, suppliers, or any other relevant factor.

Make sure to go through this section and carefully consider the risks before buying any IPO shares.

8. Avoid Subscriptions Trap

Some IPOs create a fear of missing out (FOMO), especially when everyone seems to be applying for it.

You may hear people saying, “This IPO has a demand that is 20 times higher than the supply. It is such a great opportunity – I wish I had applied earlier!”

Similarly, a friend might say, “Wow, this IPO gained 100% on listing! It is a sure thing!”

However, a high subscription does not always mean that the company is a good buy.

At the same time, a stock that gains significantly on listing is not necessarily a good long-term investment.

It is important to separate hype from substance when it comes to IPO investing.

IPO Checklist for Beginners

Before you apply for an IPO, use this simple checklist to ensure that you are making the right move:

• Do I understand the company’s business model?
• Have I studied the company’s financial performance?
• Is the IPO valuation rational?
• Have I reviewed the details about promoters and management?
• Do I know how the IPO proceeds will be used?
• Have I carefully considered the risks involved?
• Does this investment align with my financial goals and risk tolerance?

If you cannot answer these questions, do more research before you apply.

Conclusion

An IPO can be a great way to buy shares in a company at the beginning of its public journey.

However, not every IPO is a good buy.

Before you apply for any IPO, spend some time learning about the company, including its financial performance, IPO valuation, promoters, use of proceeds, and risks.

Most importantly, avoid the subscription trap and make rational decisions based on facts, not hype.

At The Safe Trader Academy, your safe space for stock market education, we want our readers to be smarter investors.

This is why we share guides, including this IPO investing guide, on fundamental analysis, valuation, risk management, and other important topics.

Remember, an IPO can be a great investment opportunity. However, it is important to research before investing to avoid losing hard-earned money.

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