IPO Analysis: How To Analyse an IPO

In the previous chapter, we learned about the process of IPO and how an IPO works. In this chapter, we’ll learn how to analyse an IPO and understand the details of a Red Herring prospectus. 

An Initial Public Offering (IPO) marks a significant milestone for any company transitioning from private to public ownership. As an investor, knowing how to analyse an upcoming IPO thoroughly can help you make informed decisions about whether or not to participate in the offering.  

This comprehensive guide will walk you through the key aspects to evaluate when conducting due diligence on an IPO, equipping you with the insights needed to determine if it aligns with your investment goals and risk tolerance. We will explore the intricacies of decoding the voluminous Red Herring Prospectus, understanding financial statements, assessing growth drivers, evaluating risks, and gauging suitability to help you navigate IPO investments confidently.

Understanding the Red Herring Prospectus 

Definition and Importance of Red Herring Prospectus

The Red Herring Prospectus (RHP) is the key document that provides comprehensive information about a company planning to launch an IPO. It is akin to a treasure trove detailing a company’s operations, financials, business model, risks, objects of the issue and more to help investors thoroughly analyse the IPO opportunity.

As per Indian law, all companies that intend to attract money through the initial public offering must file RHPs with the Securities and Exchange Board of India (SEBI) first and then with the Registrar of Companies. This strict requirement guarantees transparency and allows investors to make a well-informed decision about investing in an IPO after studying the RHP.

Another role of the RHP is to provide a base for the due diligence to be conducted before investment in an IPO. Decoding and analysing this exhaustive document is essential to gain clarity on aspects like:

• Company overview, product/service, competitiveness
• Types of revenues and their models.
• The assessment of the financial health of a company through past performance.
• Risk drivers and control measures.
• Proceeds from the offer of the shares
• Management capability
• Reasonable valuation

Given how the RHP comprehensively captures both risks and growth prospects, it provides the tools for investors to gauge if the IPO investment aligns with their goals and risk appetite. Additionally, since it is a legally binding document, companies take utmost care to ensure the accuracy and adequacy of disclosures in the RHP.

Therefore, while overwhelming in length, the RHP is an invaluable resource for prospective IPO investors. Thoroughly evaluating this pre-issue document can reveal deep insights to inform investment decisions.

Legal and Regulatory Framework in India

In India, SEBI mandates strict compliance requirements for companies planning to raise capital via an IPO under the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018. These regulations specify the disclosures an RHP must contain, ensuring the standardisation of information provided to investors.

Some key guidelines include:

• SEBI should approve the RHP before registering with the RoC
• It must be signed by all directors, the Chief Financial Officer, the Compliance Officer, bankers to the issue and lead managers
• Any changes to the initially submitted draft prospectus must be highlighted  
• Material information that investors require for making an informed decision should be adequately disclosed

Additionally, some critical information that an RHP must disclose as per regulations includes:

• Purpose of the IPO
• Promoter backgrounds 
• Financial details of the past three years
• Auditor qualifications and reservations, if any  
• All outstanding litigations and contingent liabilities
• Basis of issue price, including valuations  
• Review of business operations and industry landscape
• Risk factors associated with business and issue

Therefore, SEBI ensures that transparency and completeness of disclosures enable investors to analyse every aspect of the IPO detailed in the RHP before making their investment decisions.

Company Overview

History and Background 

One of the initial sections to focus on within the RHP is understanding the company's background. Tracing the origins of the business, evolution of products/services over time, key events and milestones in the company journey reveal essential context. 

Aspects to evaluate include:

• Year founded and promoter history
• Timeline of critical events - mergers, acquisitions, product launches  
• Geographical presence and locations of operations
• Significant strategic partnerships 
• Major investments attracted  
• Promoters Holdings

Evaluating this background equips investors to assess the company’s track record and provides the foundation to gauge future performance. Brand lineage and longevity also serve as an indicator of competitive positioning.

Business Model and Revenue Streams

After tracing the company’s origins, the next step lies in decoding the business model. This section offers clarity on the following:

• Products and services offered
• Key customer segments targeted  
• Distribution channels leveraged to serve customers
• Dependence on suppliers or vendors, if any
• After-sales servicing 

Understanding revenue streams and monetisation strategies is critical to gaining perspective on business drivers and factors impacting profitability. The prospective IPO investor must analyse and gauge the following:

• Revenue mix - contribution of critical products, services, geographies
• Asset-light or capital-intensive nature of business  
• Scope for innovation in products/services 
• Business segment growth trends and outlook
• Significant developments since the last financial statement  

Evaluating these elements will offer insights into the defensibility and sustainability of the operating model and relative competitiveness.

Financial Health Analysis   

Review of Financial Statements  

The foundation of IPO due diligence lies in intensive financial analysis. Decoding past performance through financial ratios is the most objective starting point towards determining investment potential and reasonable valuation.  

While the extensive audited financial details may seem complex to interpret, focusing on key trends and metrics can provide a balanced perspective.

Profitability and Revenue Trends   

Analyse profitability over time measured via margins and traditional measures:

Metrics to evaluate:

• Gross margin   
• Operating margin
• Net profit margin   
• EPS 

Study both the absolute profits and margins along with growth rate over time to gauge trends. Declining margins or unsustainable growth could signal financial risks. Gather reasons behind any exceptional performance.  

Alongside margins, study working capital cycle days trends to assess potential liquidity or management efficiency issues if cycle days are prolonged.

Additionally, analyse causes behind significant annual deviations in profit metrics - one-time losses/gains, impairment charges, forex fluctuations, etc - that have augmented or reduced profits. 

The revenue mix and segment growth analysis can also offer estimates of future performance based on where maximum growth opportunities lie.

Debt and Equity Ratios

Gauge past capital structure and analyse: 

• Optimal debt-equity mix
• Interest coverage capacity 
• Extent of leverage
• Cost of capital comparison with peers

Study debt repayment track records and credit ratings to determine financial position stability.

Analyse if inorganic strategies like mergers and acquisitions have skewed capital structure in recent years, impacting ratios.

Finally, compare applicable financial ratios across peer/industry averages to identify any outlier metrics.

Market and Industry Analysis   

Industry Overview and Market Position  

Gaining perspective on the sector landscape equips investors to estimate growth viability and commercial risks and gauge the company’s positioning relative to competition. 

The RHP industry overview, coupled with further research, should reveal critical aspects:

Market Size - Indian and Global Potential  

• Historic growth rate
• Forecast future expansion outlook 

Market Attractiveness Factors

• Trends shaping sector evolution  
• Drivers fuelling commercial activity 
• Untapped segments  

Competitive Forces 

• Key players  
• Market concentration ratios
• Emerging disruptions  

Regulatory Factors

• Policies governing the sector  
• Impact of interventions
• Ease/challenges of compliance

Benchmark company’s market position against competition

• Market share analysis 
• Share in key customer segments/products
• Competitive positioning  

The growth outlook is positively influenced by conducive regulatory policies, a dynamic, fast-growing market, fragmented competition and the company’s strong market position.

Competitive Landscape in India

Evaluate the company’s sources of competitiveness relative to rival players. Assess:  

• Barriers to Entry: Factors protecting incumbent player market share against the competition - technology innovation advantages, high capital needs, customer captivity due to high switching costs, etc. For example, technology companies enjoy market dominance protected by a constant innovation pipeline, while companies relying on distribution models retain market leadership through extensive channel partner reach, limiting competition.
• Bargaining Power of Suppliers: Analyse risks to the business model from supplier actions - shortages/price hikes of critical materials or services sourced from monopoly/monopsony suppliers.  
• Bargaining Power of Consumers: Assess risks arising from enhanced buyer bargaining muscle - consumers enjoying added negotiating leverage to demand price reductions due to market fragmentation or commoditization squeezing seller margins. 
• Threat by Substitute Products: Evaluate the threat posed by alternative products making core offerings redundant. Changing consumer preferences and the emergence of disruptive models rendering existing products obsolete accelerate this risk. 

The investment merits are higher for a company insulated from competitive forces in a rapidly expanding market.  

Future Growth Prospects and Market Trends

The investment decision calculus should weigh potential future growth trajectories balanced against current financial valuations. Evaluating growth prospects entails gauging:  

Company Growth Strategies 

• Vision to harness opportunities  
• Innovation pipeline 
• Inorganic expansion plans
• New market development 

Category Growth Trends

• Structural consumption shifts
• Premiumisation openings  
• Adjacent segment inroads
• Channel mix shifts like online adoption  

Long-term Steady Demand Drivers 

• Macroeconomic stimuli  
• Urbanisation
• Favourable demographics
• Accelerated adoption  

Considering the triangulation between company strategies leveraging industry tailwinds in light of market drivers provides a perspective on investment horizon potential.

Management and Corporate Governance 

Profiles of Key Management Personnel

The future performance projection of any enterprise hinges significantly on the vision and execution capability of its leadership team. Evaluating pedigree, experience and tenure offers cues to gauge execution risks. 

• Profile career background - founders and professional CEOs 
• Track record of performance  
• Vision and growth strategy  

Founder-led management teams bring deep customer centricity forged from entrepreneurial journeys and an understanding of market needs. However, professional management leadership could bring stability, process rigour and global savvy. 

Optimal leadership teams balance passion and prudence. Review historical management decision efficacy in light of business growth attained. The long, stable tenure of crucial management inspires investor confidence.   

Corporate Governance Practices

Strong governance standards signal the company's emphasis on equitable, transparent processes that mitigate risks of mismanagement and non-compliance and enhance disclosure credibility and financial control reliability.

Key areas to evaluate policies and mechanisms on:   

1. Board Independence Ratio:  Optimal board independence levels should mandate the inclusion of significant independent directors, though a minimum of 1/3rd of members is compulsory for listed companies as per Indian regulations.
2. Independent Audit Function: Assess auditor background, capabilities and any reservations/qualifications cited earlier impinging on financial statement credibility. Further, the rotation of auditors periodically enhances objectivity.
3. Disclosures and Transparency: Review frequency, content depth and channels of disseminating financial results, annual reports and investor communication materials. Ready access to relevant company material repels ‘information asymmetry’ between company management and shareholders, enabling data-driven decisions.
4. Related Party Transactions: An elaborate and explicit related party transactions policy reinforces checks preventing conflicts of interest and arbitrary favourable arrangements with special interests at the cost of minority shareholders. 
5. Grievance Redressal: Streamlined complaint mechanisms and responsiveness to investor queries signal regard for shareholder interests.

Past Performance and Management Decisions  

In conjunction with financial and operational analysis, a nuanced understanding of past management decisions explains performance over the years. 

These perspectives shed light on future actions and growth strategies, whether beneficial or risky. For example, an aggressive inorganic expansion drive may have burdened the balance sheet but gained market power. 

Probing the outcomes of key strategic pivots by interpreting past annual report commentary offers cues to determine if management has displayed sound judgement and whether their growth plans appear coherent. 

IPO Details and Valuation

Offer Price and Valuation Methodology  

Equipped with financial analysis and an understanding of competitive position, an investor can proceed to assess the reasonability of the IPO offer price valuation. RHP details the methodology applied towards arriving at the valuation based on established principles.

Preferred valuation approach depends on sector and stage: 

• Startups: Discounted Cash Flows (DCF), Enterprise value/Sales multiples (EV/Sales) 
• Banking and Finance companies: Price/Book Value multiples
• Technology firms: Revenue multiple/Price-Earnings ratios based on relative valuations  

The RHP discloses key assumptions behind cash flow forecasts based on past performance used to compute intrinsic value in the case of DCF. 

P/E-based valuations reveal peer benchmarking insights after factoring in growth rates. Ensure consistency regarding standalone or consolidated financials used across documentation. 

If research analyst valuations are available, compare disposable information on valuation estimates from multiple experts with RHP content. This allows for gauging offering attractiveness.

Comparison with Industry Peers  

Essential valuation sanity checks involve comparing IPO pricing with relevant listed industry comps on key financial parameters. This peer analysis serves to identify any overvaluation or underpricing of the issue.

Key metrics for comparison:   

• P/E ratio relative to growth rates  
• EV/EBITDA
• Price to Book Value 

Adjust industry averages for company stage, scale, and growth variances while concluding. New economy stocks command valuation premiums owing to technology and first-mover advantages.

Ensure the peer group considered for comparisons faces similar cost structures, targets the same customer cohorts and holds coherent context justifying premiums or discounts in valuation multiples.  

Shareholding Pattern Post-IPO

The share allocation split among promoter and non-promoter shareholding reveals the extent of dilution and influence of founders post-listing. 

Analyse shareholding restructuring:

• Promoter stake pre and post-IPO
• Fresh issue size dynamics 
• Anchor investor share allotments

Interpret dilution objectively, accounting for the company’s growth inflexion point justifying capital injection. Some key questions to address:

Will founders retain a controlling stake and interest in steering future strategy? Have private equity funds that invested gained significant minority voting rights and oversight abilities?

Evaluate whether issue size seemed calibrated to facilitate founder partial exits or signifies meaningful long-term investments to fund capability improvements. 

How To Apply for IPO on Angel One?

1. Login to the Angel One App or website and click on ‘IPO’ on the homepage.
2. Select the IPO you are interested in.
3. Go through the IPO details like maximum quantity, maximum investment, about the company, etc.
4. Click on ‘Apply Now’ to apply and enter the number of lots and bidding price along with your UPI ID.
5. Confirm your bid and accept the payment mandate sent to your UPI App for successfully completing the IPO application.

That’s it! Your IPO order is placed. You can check the status of your IPO in the ‘Order Book’ section.

Risk Factors

While inherent industry and business uncertainties exist, hampering every entity’s performance, some vulnerability areas have higher negative consequences. By scanning risk factors specifically flagged in offer documents and wider research materials, investors comprehend downside dangers adequately account for while projecting returns.

Specific Risks Mentioned in the Prospectus

Every RHP carries an extensive section indicating enterprise and issue-related risks categorised across operational, financial, macroeconomic, regulatory, compliance and litigation exposures. 

Some risks are disclosed more for legal disclaimers, while certain vulnerabilities require greater attention. Focus areas for investors could include:  

Business Model Risks  

• Input cost escalations  
• Demand cyclicality  
• Market acceptance uncertainties
• Product obsolescence  

Financial Risks

• Liquidity crunch chances 
• High working capital needs
• Client concentration & credit defaults

Exceptional Risk Exposures 

• Pandemics impacting verticals like retail, travel, etc
• Client contractual clauses enabling abrupt exit

Major litigation risks signal investors to probe deeper and gauge potential damages ahead through independent research before risking investments.

Industry and Market Risks

Besides company-specific risks, sectoral market changes can equally unfavourably impact return generation capabilities.

Environmental shifts should be accounted for:  

• Emerging substitute threat
• New disruptive competition
• Demand contraction or upheavals
• Cost inflation narrows margins
• Tightening regulations  

Technological disruptions, geo-political conflicts or black swan events may unexpectedly alter industry dynamics suddenly. While unpredictable, seemingly stable sectors may not be immune either.

Operational and Financial Risks  

Operational risks gravely impact execution capabilities, while financial risks diminish stability and survival abilities. Among key functional areas evaluated:

• Input material/services – cost or availability volatility
• Inherent process complexities need precision
• Output quality control failures  
• Technology systems risks – integration, breakdowns
• Human capital risks – high attrition, inadequate skills

Financial vulnerability areas encompass:  

• Leverage levels narrowing interest coverage capacities  
• Slim liquidity buffers imperilling working capital needs
• Major customer revenue concentration hazards 
• Foreign exchange exposures towards exports/imports

Investors should account for such operational and financial risks amplified by thin buffers limiting shock-absorbing abilities.

Use of Proceeds from the IPO

Planned Allocation of Funds 

Analysing planned usage of capital raised via IPO provides cues on the founder mindset, business model capital intensity and growth avenues perceived as investment-worthy by the company. 

Typical capital usage towards:

Organic Growth Plans  

• New products/market development 
• Augmenting marketing capabilities
• Enhancing production capacities
• Technology infrastructure advancements
• General corporate expenses

Inorganic Growth Strategies  

• Potential acquisitions
• Strategic partnerships access
• Synergistic investments & JVs

Financial Obligation Resolution

• Refinancing high-cost debt
• Working capital enhancement 
• Paying off creditors 

The offer document would specify allocations across the avenues as mentioned above customised to issuer imperatives, signalling business outlook and imperatives.

Expansion and Investment Strategies

Compare capital usage plans to the company’s historical investment patterns and stated strategies in annual reports indicating its priorities. This assessment helps investors gauge if funds usage aligns with business model needs and focused areas the company wants to double down towards. 

Imperative objectives funding requires calibration on the quantum of capital allocated towards resolute scale efficiency creation or strengthening competitive moats through superior manufacturing, marketing, or technological prowess from proceeds raised. Divergence from clarified priorities usage plans sends caution signals on potential fund utilisation sub-optimality. 

However, entirely debt repayment-focused proceeds usage rings investor alarm bells on the company’s financial crisis or promoter intentions regarding capital recycling for personal enrichment. 

Essentially, capital usage justification coherence to the company’s operating context and declared strategic plans determine funds deployment optimisation and eventually multiplier investor returns. So, the decoder ring perspective reveals the founder's mindset and forethought.

Investor Considerations

Expected Return and Risk Profile

With extensive financial analysis insights, an understanding of industry dynamics, and management capability perspectives in place, an investor can proceed towards estimating expected returns. 

The investment decision driver determination entails factoring probabilities balanced against value creation time horizons. An analytical framework encompassing both quantitative and qualitative elements considers:  

Returns Magnitude Potential  

1. Revenue growth estimation: new market entries, product/category upgradation opportunities fuelling consumption growth  
2. Profitability margins scope: operating leverage and future capital structures are typical inputs for price margin estimation.
3. Reinvestment rates sustain healthy growth.
4. Balance sheet strengths: capabilities supporting inorganic expansions and external shock resilience

Returns Risk Profile 

• Industry growth uncertainties and demand cyclicality possibilities  
• Intensity of competition 
• Execution risks - historical volatility  
• Corporate governance credibility 

Returns Realisation Timelines

• Growth acceleration trajectory matched to sector maturity: growing new economy sectors exuberate returns quicker
• Company life stage: early growth phase entities confer longer duration holding power  

Striking the proper balance between return expectations, risk exposures, and investor time horizons dictates the IPO investment that the investor makes. 

Long-term vs Short-term Investment Horizon 

IPO investing by underlying construction necessitates adopting medium to long-term investment horizons given the gestation periods new ventures require towards establishing market leadership and attaining scale. However, some scenarios suit investors with short-term horizons:

Short-Term Investors (6 months - 1 year)

• Focus on oversubscribed IPOs indicating strong initial demand-supply imbalances enabling listing gains exits  
• Target underpriced IPOs based on comparisons with industry comps, enabling rapid price corrections driving stock value unlocking 

Medium Term Investors (1-3 years) 

Evaluate return generation time horizons matching business growth trajectories.  

Long-Term Investors (>3 years)

Assess the company's life stage, target industry growth rates and company competitive positioning as market leader indicators on extended holdings durations.

Therefore, category dynamics and issuer context merits determine ideal investment horizons matching required value creation timeframes. 

Suitability for Individual Investment Goals  

Apart from return objectives, an individual investor’s personal portfolio investment goals greatly influence IPO investing decision suitability. 

One’s risk appetite, liquidity needs, and wealth creation need to align with the IPO issue profile on parameters spanning:

Risk Appetite Alignment  

• Aggressive Risk-Taking Appetite: Invest in startup IPOs across new economy sectors like technology, E-commerce, and digital plays, given higher risk-return payoffs
• Moderate Risk Appetite: Focus on emerging leaders in growing export-oriented sectors 
• Conservative Risk-Taking Ability: Mature sector with market leaders IPOs that can provide better stability 

Wealth Creation Needs

• Long-term Capital Appreciation Goals: High growth potential but loss-making IPO issues 
• Moderately Paced Wealth Increase Needs: Profit-making Small & Midcap IPOs  
• Income Generation Focus: Mature companies with stable dividend payout histories  

Regulatory and Legal Aspects

Compliance with SEBI Guidelines   

Given that the RHP serves as the legal offer document for IPO proceedings, strict adherent guidelines issued by SEBI include:

• Financial details disclosures 
• Risk factors inclusion  
• Utilisation of issue proceeds intentions
• Shareholding patterns declaration
• Mandating sign-offs by investment bankers

Ensure the RHP content does not violate stipulated guidelines, with specific attention if:

• Financial data reconciles with available information in the public domain from reliable sources 
• Statements made are adequately backed by relevant graphs, charts and ratings
• No misrepresentation through statements out of context, inaccurate claims, misleading graphics

Independent checks on the credibility of disclosures signal reliability reassurances to investors scanning the RHP draft.

Legal Obligations and Rights of Investors

From a legal standpoint regarding IPO proceedings, an RHP registers a binding contractual obligation upon the issuer with SEBI-protected investor rights as a securities market regulatory overseer governing the following:

• Assuring veracity of disclosures and financial statement credibility, preventing falsification intended towards misleading investors through mandated auditor sign-offs on financial data 
• Enabling reliance on declarations made in RHP preventing post facto selective disclosure emergence or data ambiguities preventing factual distortions through fairness doctrines
• Recourse options to investors regarding grievance redressal towards issuer non-compliance or business model risk materialisation through regulatory enforcement  

Therefore, legal resources augment investor trust in system fairness, driving interest and participation.

Analysis of Past IPOs in India   

Investors analysing an upcoming IPO benefit from perspectives from evaluating prior IPO journeys of issuers operating in the same sector or peer group context. Learning from their post-IPO stock performance history and aspects explaining subsequent value creation or erosion enriches decision-making capacities regarding the imminent IPO.

Historical Performance of Similar IPOs  

Studying indicators driving listing gains or underperformance across relevant listing comparables:

Successful IPO Stock Performance  

• Effective demand and supply imbalances drive oversubscription, enabling strong debut gains to allow exits for short-term investors  
• Impressive financial results enabling price uptrends reflecting fundamental performance or higher growth prospects based on market leadership or financial ratios outpacing the industry  

IPOs Industry Underperformers

• Inordinate promoter exit driving negative signalling amounted to excessive valuations.  
• Failure to create sustained competitive advantages reflected in market share losses extinguishing investor interest  

Thus, evaluating prior comparable IPOs' stock price performance explains factors that determine either bullish uptrends or bearish corrections. This allows parallels to be drawn regarding return trajectory possibilities.

Lessons Learned and Best Practices

Key analysis takeaways from subject IPO comparable journeys post listings include:  

The importance of financial analysis is gauging capabilities on growth feasibility and cash flow upstream sufficiency towards value creation. Growth irrational exuberance judgement errors lead to bubble valuations, while financial distress trends predict stock price declines.

Due diligence assessing management credibility and corporate governance standards offers cues on execution effectiveness and information transparency relied on by investors in long-term value creation journeys requiring staying power. Failures on either count compound ordinary business model risks.  

While each IPO business differs based on competitive landscape dynamics and general economic scenarios shaping end-market demand, evaluating transaction experience precedes fast-track capability development regarding separating investment-grade IPOs matched to investor aspirations amid a market abounding with opportunities.

Conclusion

In summary, meticulously analysing a Red Herring Prospectus requires encompassing a multi-dimensional approach to inspecting financial statements, business model competitiveness, industry attractiveness, management pedigree, reasonable valuations, and risk exposures. Supported by learning from previous IPO case studies, the due diligence insights obtained from this comprehensive exercise equip investors to determine if the IPO opportunity matches their risk appetite and return profile preferences within defined investment horizons.

No single parameter dictates decisions. Evaluating both quantitative and qualitative factors enables balanced judgements. Thorough analysis facilitates data-driven decisions tailored to investor goals. Thus, the RHP analysis journey helps separate the wood from the trees when pondering IPO participation amid a market teeming with possibilities for making the most of this tactical wealth creator during dynamic times.

In the upcoming chapters, we’ll learn more about the allotment process of IPOs and understand how you can subscribe to IPOs.  You can explore IPOs and their details on the Angel One app in one place rather than finding different places for every piece of information.