Things to keep in mind when investing in IPOs

Internet provider Converge ICT Solutions is scheduled to conduct its initial public offering (IPO) later this October, after recently receiving an approval for its application to list from the SEC and the PSE.

To buy or not to buy? Here are some things to keep in mind when deciding whether or not to subscribe to Converge or to any other company’s IPO in the future.

Is the company growing? A company’s growth outlook is very important in determining whether or not its stock will perform well once it lists in the market.

Determine whether the company doing an IPO belongs to a growth industry, a mature industry, or a sunset industry. Study the company’s historical earnings performance and determine whether sales or profits are growing in line or faster than the industry. The priority should be to invest in companies that belong to growth industries and that have a proven track record of delivering above average growth.

Determine if a company’s strong performance is sustainable. What is the company doing differently

that allows it to grow faster than its competitors? Does it have a competitive advantage over other companies or is it just lucky? What does it plan to do to sustain growth in the future?

Where will the IPO proceeds be used? There are many reasons why a company may want to do an IPO. Although reasons are varied, investors need to find out where the bulk of the IPO proceeds will go—either to existing shareholders or the company. This can be determined by looking at the breakdown of the types of shares being sold.

Funds raised by selling primary shares will go to the company, while those raised by selling secondary shares will go to existing shareholders. Although there is nothing wrong with the sale of secondary shares by existing shareholders, the company should also be able to raise enough money for itself to either reduce its debts or fund its expansion so that earnings can grow at a faster pace.

How much is the stock being valued? For an IPO to be successful, the company must price its shares at a reasonable valuation. Valuations are even more important for bigger companies doing an IPO since they will need to convince more investors, including large foreign institutional investors, to buy their shares so they can raise bigger capital.

The first step in valuing a company doing an IPO is to derive an estimate of full-year profit. The next step is to compute the company’s P/E ratio based on its IPO price and the estimated full-year profit and to compare it with the P/E ratio of other companies belonging to the same industry in the Philippines and in the region.

The company’s P/E ratio should ideally be lower than the average multiple of its peers. If it is higher, there should be a compelling reason for the premium. Does the company have a dominant position, a more attractive growth outlook, or a stronger balance sheet compared to its peers?

If the premium cannot be justified, you might be better off waiting for the company to list on the PSE and for its share price to drop to more attractive levels before buying. After all, a good company can become a bad stock if it is priced expensively.

With this framework, I hope you will no longer rely on tips or rumors in deciding on whether to subscribe to any upcoming IPOs. If you find the process too intimidating, your stockbroker may have a report summarizing its analyst’s view on the company doing an IPO. Just remember, a well written report should cover the three topics mentioned above— growth outlook, use of proceeds and valuation—and should be the basis of whether or not the analyst has a favorable view on the IPO. INQ

By: April Lee Tan

Source: Peso Economics