There is a lot of excitement in the investor community around an Initial Public Offering or IPO. IPOs are attractive for investors owing to the underlying belief of buy low and sell high.
It is a common belief amongst investors that the stock prices would in most cases increase after an IPO. Thus, the rush to subscribe to quality stocks of companies with sound fundamentals at a reasonable price. We shall discuss the steps to buying shares in an IPO issue.
Why Do Companies Offer IPOs?
Companies raise funds from the capital markets via an IPO issue. The capital raised could be channelized for diverse business needs like capacity expansion, product diversification, entry into a new geography, a significant R&D initiative, merger and acquisition activity etc.
The disclosure of proposed usage of the funds is to be mentioned in the issue prospectus.
The advantage for a company to raise funds via an IPO over other traditional financing channels like loans etc is the visibility in the public and the opportunity to improve market capitalization.
The layman gets an opportunity to buy shares and hold a small stake in company ownership. Thus from the valuation perspective, it makes sense for companies to opt for the listing route.
What Are the Types of IPOs?
Broadly an IPO includes the following types:
If a company is raising capital for the first time from the primary market and getting the company stock listed on the stock exchange, such an IPO is called a new offer. This expands the shareholder base of the company and injection of capital into the company.
In such a case, the company is already listed in the stock exchange with company shares being traded in the market. However, the company is keen to raise additional funds via the IPO route. Such an issue is called follow-on offer.
Offer for Sale
In case of an offer for sale, the current promoters and anchor investors sell a part of their shareholdings via an IPO. In case of Government entities, most of the disinvestments are through offer for sale. Thus, while the share capital does not grow, the share holding pattern undergoes a change.
The offer for sale route may also be used by a closely held company to list in the stock exchange.
Why Should an Investor Consider Buying IPO Shares?
In an IPO issue, investors can buy shares of the issuing company by investing money and become shareholders of the company.
Depending on their shareholding, shareholders are entitled to dividends, bonus shares etc based on the earnings of the company and declaration by the management of dividends or bonus issue. Historically, equity has generated higher returns than other asset classes.
Thus, it is prudent for investors to hold a certain portion of equity in their portfolio. However, equity is also considered risky as the share prices are prone to frequent fluctuation based on economic and non-economic events and often, without any particular reason.
In the long run, however, investing in the share market can help in wealth creation by investing in valuable stocks of reputed companies with a robust business model and financial performance. An IPO is an opportunity to pick winning stocks and invest at a competitive price in the shares of future industry leaders that provide valuable earnings by way of stock appreciation.
Due to the reasonable price, one can buy multiple shares of the issuer company at a reasonable price. After the company has already established itself, it would be very expensive to buy multiple shares of the company as the current market price would be high.
What are the Types of Pricing in IPOs?
The IPO pricing is broadly of two types- the fixed price IPO and the book-built IPO.
Fixed Price IPOs
In this case, the IPO price is fixed in prior as the sum of the par value and the premium. Potential investors can apply for shares in an IPO issue at this declared price. The price is fixed by the company.
Book Built IPOs
In this case, an indicative price band exists for the IPO issue and the final price is discovered as part of the book building process. This is similar to an auction where the forces of supply and demand determine the price.
Most IPOs are issued through the book building process. Many a time, in case the stock is oversubscribed, the shares are bought at a premium pricing.
This leads to huge gains for the company, due to the enhanced value placed upon the company shares by investors.
What are the Classes of Investors in IPO Issue?
Broadly, investors investing in IPOs may be classified into retail, high net worth individuals and institutional categories.
SEBI encourages the active participation of retail investors by a specially designed allotment method, which enabled maximum allotment to individual investors.
This is done to ensure high liquidity and a profit-making avenue for individuals by trading in shares in the secondary markets.
The allotment of shares in an IPO issue is proportional.
The allotment method as per SEBI is discretionary.
How Can One Apply for an IPO?
One can bid for IPOs through the online or offline method.
In this method, the interested investor needs to fill the requisite physical form and submit the same to the IPO banker or the broker.
One can directly log into the online trading portal, offered by one’s broker. In this case, the data is directly retrieved from one’s trading and demat account. This simple method is preferred by a majority of investors.
In case of a book built IPO issue, the rationale of allotment is confirmed within 10-12 days and the demat credit of shares allotted promptly follows.
After receipt of the shares and the listing of the company stock, one can sell the shares via a trading account.
SEBI has enabled a convenient feature called ASBA (Applications Supported by Blocked Amounts). The benefit is that one need not have to pay for shares till the final allotment is made.
The amount is debited from the bank account only to the extent of the payment for allotted shares. For example, if an investor applied for shares worth Rs. 1 lakh but was allotted shares worth only Rs. 50,000, then only Rs 50,000 would be debited from the bank account and the hold on the remaining Rs. 40,000 would be removed from the bank account.
What are the Steps to Invest in an IPO via the Online Route?
These are the major steps that you must follow to invest in an IPO
1. Zero in on the IPO Choice
It is important to decide on which IPO one desires to apply for. One can download the company prospectus from the SEBI website to get a thorough understanding of the business model, management experience, revenue stream, risks, strengths, the viability of the business plan and the rationale behind the fundraising.
The next step is to arrange for the funds to be invested while applying for shares. In case one does not have sufficient funds, some financial institutions extend loans at competitive interest rates.
3. Opening the Required Account with the Broker
It is absolutely necessary to have the following three accounts for buying shares in an IPO:
When one wishes to buy shares in an IPO issue, the money is transferred from the bank account to the trading account to settle the transaction. The stockbroker would link the bank account to the trading and demat account.
This account enabled one to place buy or sell orders for shares issued in an IPO. One can also invest in derivatives, options, mutual funds etc via a trading account.
This account holds the shares in a dematerialized or electronic form.
One needs to apply online through the broker trading platform. The ASBA option has been made mandatory for IPO applications.
This provision allows banks to block a sum of money equivalent to the value of shares applied for. One needs to share bidding details like number of shares applied for etc. ASBA can be availed in physical and demat form.
One needs to bid for shares based on the lot size specified in the prospectus. The lot size is the minimum number of shares that one needs to apply for during an IPO application process.
The company specifies a price band with the upper range known as the cap price and the lower limit known as the floor price. The potential investor needs to bid for a certain number of shares based on the bid price falling within this range.
It is possible to revise one’s bid price. It is mandatory to block the money equivalent to the bidding amount. This money remains blocked in the bank account and earns interest until share allotment.
It is quite possible that the demand exceeds the supply of shares issued in the primary market. Thus one might obtain fewer shares than initially applied for or even fail to obtain any shares. In these cases the bank would unblock the money held as ASBA.
In the event that one obtains allotment, the investor would be given a Confirmatory Allotment Note (CAN), within 6 working days of the book-built issue. Upon allotment, the shares are credited to the demat account. The listing of shares happens within seven days from the closure of the issue. Post the listing, one can trade or sell the shares to book profits.
What Should One do Before Investing in an IPO?
Ideally, one should have a deep knowledge of the industry and the company which one is planning to invest in through the IPO issued shares.
One must thoroughly analyze the financial performance and the future business prospects of the company and the sector. It might be possible that a company which is a startup today and is issuing an IPO would go on to become an industry leader.
Most established and well-performing companies today with a large market capitalization started off with an IPO issue at some point of time in the initial growth phase. Thus, it’s important to separate the wheat from the chaff i.e. pick quality and valuable stocks at a fair price.
In conclusion, it must be remembered that it’s not always necessary that every IPO will perform well. In fact, Buffett’s strategy is such that he does not seem inclined to take bets on untested companies.
Legendary investor Buffett is believed to have invested in an IPO last in 1955 when Ford Motors came out with an IPO issue. Thus, it’s important to do one’s homework and conduct sufficient due diligence before looking to buy an IPO issue.
Don’t go by hearsay, marketing advertisements, herd mentality or popular sentiment! To conclude in the words of Buffett: ‘Price is what you pay. Value is what you get’!
Disclaimer: The views expressed in this post are that of the author and not those of Groww
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