Reading an IPO prospectus: what it says and what it doesn’t

New share offers are a thing of joy in a bull market. They promise to bring quick gains within two days of investing the money.  In season, too many people chase the IPO, the allotment is a lottery and most retail folks get allotment of shares valued at about Rs.15,000, which is considered as “one lot”.  And of course, there is the “HNI” category where you have a shot at bigger allotments. Many resort to NBFC funding which is available in plenty, to improve their odds in this lottery. 

The lottery approach

In the old days, we could get hold of an ‘abridged’ offer document or prospectus for an upcoming IPO well ahead of the offer. We had enough time to go through and read whatever we wanted. Today, the IPO prospectus is called a “DRHP” or a “Draft Red Herring Prospectus”.  The price is not available in this. Merchant bankers and the regulators have contrived to make it run to four hundred pages at the minimum, with some even going to a thousand pages, with the important information buried in tonnes of mandatory disclosures! 

This prospectus is in electronic form. Many brokers will give you a link to it, but the link will not work. They know no one actually downloads and reads all the silly stuff. Most of us look at some popular websites, see the grey market ‘premium’ and simply put in our IPO application. And given that we only have to block our money, the urge to apply is compelling. Everything done from the mobile phone. No clue about what the company is about, what is the valuation etc. If we win the allocation lottery, the first thing is to sell in on listing day and pocket the money. Retail investors usually want to decide on their applications based on the noise level in the media and the HNI will decide on the basis of the grey market premium. Institutional investors go by the market mood and generally tend to be supportive as they keep needing favours from the bankers who market these issues. All this makes for a nice game.

The rational one

Now, let us try to be rational investors. If so, what is the information we need? If you cut the clutter, here are the essentials to look for. 

1. What does the company do?  What does it make? What is the value add? Who does it sell to? Is it B2B or B2C? Since how long has it been around? Is the business scalable? Who are others in this space? Can new entrants come in easy? How long has the company been in business? How is the business growth rate?
2. How has the current share capital been constructed? How much money in cash did the promoters put in? What were other issuances? When did the last equity infusion take place and at what price? What would be the total paid up capital after the issue? What would be the market capitalization at issue price?
3. Can we get some idea of the promoter and his background? Any other companies he is associated with? How many family members on board? What is the total amount taken out by the family in salaries/allowances/ESOP etc over the past few years? What will be their stake after the issue? Is the issue money going to the company or to the exiting shareholders? Is there a credit rating already in place?

Here is a contents page of a DRHP from a recent issue. Let me tell you what pages I will ‘skim’ through :

What to look for

I will start with “Summary of Financial Information”.  Then go to the section about “our business”. Will glance at “promoter group”, “group companies”. Then I will go to “Financial Indebtedness”. I may not go through the detailed financials at this stage. I will skim through the litigation section. I will go through the section of ‘dealings with related parties’ in detail. I want a snapshot that looks like this:

1. Market capitalization plus debt at the upper end of the price band 
2. Sales for the last twelve months
3. Issue price of the last issue
4. Promoter skin in the game. Post issue stake in percent and rupee value of what he has put minus what he has taken out over the last few years as salaries, commissions and stock options
5. Value of ‘goodwill’ and other intangible assets as a part of the total
6. Whether business is balance sheet based or revenue based
7. Is the company at a stabilized stage? Or is it at a stage where the future is still taking shape?
8. Is there any listed company with who I can compare? 
9. Complexity of the corporate structure. Are there many associate companies with partial ownership? If so, I do not like it;
10. Acquisitions /mergers over the last few years. How were they paid for?
11. Regulatory risks. Can the government have a reason to tinker with the pricing, restrict or ban this business?

Selective information

However, even if I were to read every page of the DRHP, it would still leave me with questions. So, in a prospectus that is organized like the above, I would focus on the business, promoter and summarized financials (as recent as possible). Profit measures and financials disclosed at this stage are often very good and carefully dressed up, so cannot be wholly the basis for gauging the future. Remember, the issuer is offering the shares at a time and price convenient to him. As a seller, he wants the maximum price.  In a good market, the share may trade above offer price, but history says that the market price generally drifts below the offer price in a vast majority of the cases. 

These are some broad pointers. An investment decision for the long term, cannot be based on information from the DRHP alone. The DRHP after all is a selective document drafted by clever investment bankers, vetted by lawyers. Then the regulator (without owning any responsibility) also goes through the same. It still will not get you a feel for the business. Yes, if you have the skills, you can spend some time on the financials, to see what is the asset composition and whether it logically fits in with the business of the company. 

As I mentioned, the investor is being attacked by a team of professionals who are set to squeeze out the maximum from the sale of shares. And generally, the broker community does not like to say bad things. They always talk well about everyone. 

Today, most IPOs are driven by PE funds and Venture Capitalists who have invested early and want to exit through the listing route. So the selling process is predominantly driven by greed for maximization of revenue. They know the game well. Appoint a big-name auditor, get the noise level up as the issue hits the street and do everything that is necessary to maximise the take-home price. It is not at all surprising that in a very recent IPO issue, the promoters said on television that they could not say anything about the pricing, because everything about the issue was structured by the professional investors who are exiting!

Given that IPOs are such a one-sided game, seasoned investors in fact like to ignore IPOs and concentrate on the universe of listed companies that have been studied and there is a price discovery in place for a long time. IPOs crowd in in bull markets, where over-the-top valuations can be justified. If you’re keen to play the wheel of fortune still, the best strategy is to exit on listing. There are very few IRCTC type of stories where promoters leave big money on the table and IPOs listing at huge premiums go on to create further wealth.

Buyer beware

In this context, one cannot but notice that the information that IPOs put out in their public announcements, is pathetic. SEBI has to introspect on the real information that prospective investors would like to see in an advertisement for an IPO. What is the business? What is the value on listing? What is the business? Who are the customers? Why does the promoter think the business will make money? Who are the promoters?  These can be put down in a small box. Even many of the broker reviews and recommendations on IPOs do not touch on these simple things.  

Valuations during IPO times fall more in the realm of ‘art’ rather than arithmetic. Most IPOs are in the realm of ‘venture capital’ and hence, it is not really suitable for the retail investor. So, play the game with caution. In the good old days, the ‘prospectus’ would carry three year projections. Then they were done away with because they were ‘forward looking’ statements and could be used to mislead the investor. Today, the task has been handed over to the sell side analyst. As an investor, you are very very lonely in this crowd.

IPOs are a clear case of “buyer beware”. Given that the retail investor gets a marginal allotment in a bull market, even if lucky, why take the trouble at all?

Curious? Here’s a sample DRHP to look at from a recent IPO.

Note: As always our philosophy on IPOs can be found here.