Saturday, May 7, 2016

Is it Good to Subscribe to the Upcoming IPO?

Investors ask Is it Good to Subscribe to the Upcoming IPO? Lookout for new ipos and buy ipo stocks
Investor Subscribing to IPO Online Platform of Stock Exchange

Recently a professional colleague asked me if it is good to subscribe to a certain upcoming IPO. He mentioned that he always keeps a close tab on the IPO calendar as IPO stocks have always fetched him handsome returns, and he eagerly looks forward to new IPOs.

My answer is an emphatic NO!

People may argue that many good issues have yielded handsome returns or gains on listing – meaning the shares traded on the stock exchange at a price over and above the IPO offer price. 

Listing Gain should not be the Reason for Investing

I don’t deny that it is possible for a particular issue to trade at a higher price, for a short time.  But again it is fundamental difference in approach between a trader and value investor.  The question is not about price.  It is about value.  The question is whether the share being offered for subscription is at or near its fair or intrinsic value?  What price to earnings (PE) multiple is it sold? Is it ten times or near about ten times the earnings per share (EPS)?  The answer invariably is a no.  

Mostly IPO Stocks are offered at not less than a PE of 20 and some times it may go as high as 40 times the earnings.  In simple language, a PE of 20 means it will take 20 years for the company to earn the investment back for the investor, and a multiple of 40 means forty years.  To complicate the matter further, PE and EPS refer only to earnings by the company and not by the investor.  

Considering that companies hardly distribute more than 25% of their earnings to shareholders as dividends, it will take four times more number of years for the investors to recover their own investment!  Whereas the simple fixed deposit with a bank will recover the investment in 10 years, in India, assuming an interest rate of 10% per annum.  Of course, we have considered only the earnings and dividends in this analysis and not price increase either on the back of growth in earnings or otherwise.

One can Buy IPO stock Much Cheaper on the Stock Market

Even if we go by traded price on the exchanges, history shows that in the medium to long term, mostly IPO shares loose their value significantly.  One could easily buy the same shares at less than half their issue price if not more, in a few years. 

Value – that is any potential for future price growth - is almost fully extracted by the IPO company and investors are left high and dry either with losses or minimal gains. Ironically, it is not different even in the case of government owned or public sector companies.  This sorry state of affairs may be attributable more to the merchant bankers and advisors to the issue rather than the companies or their promoters or managers.

In the Coal India IPO of the year 2010, the price was fixed at Rs.245 a share.  It was billed as India’s largest IPO.  The company raised over Rs.15,000/- crores ( Rs.150 billion). The issue was over subscribed by 15.28 times. 

For the financial year ended on 31st March 2010, the company had declared earnings per (EPS) share of Rs.5.97 and book value of the share was Rs.14.67. 

It means that the shares were issued at a PE multiple of 41.03 times (245÷5.97) and a price to book multiple of 16.70 times.  Whereas, the prescribed limits in value investing, are just 10 times PE multiple and 1.5 times the book value.  This mean the fair value of the share in the IPO was not more than Rs.60.

Today (Friday, 6th May 2016) the closing price of Coal India share was Rs.281.95.  The share is trading at a PE multiple of 14.81 times and a price to book value multiple of 4.41.  Assuming that the EPS has remained constant 1t Rs.5.97, applying this PE multiple you could have bought the same share in the open market at Rs.88.41.


In the light of the above discussion with example it becomes amply clear that my friend's contention of watching the IPO calendar as IPO stocks have always fetched him handsome returns, and he eagerly looks forward to new IPOs, does not hold good, The answer to the question, "Is it Good to Subscribe to the Upcoming IPO?" is a definite no.