Practical stock researchModule 2, lesson 10 of 23
Evaluating an IPO
How to read an IPO's red herring prospectus, check the use of proceeds and offer for sale, compare earlier investors' prices, and value it against peers.
In this lesson
- Find the main sections of an offer document and what each reveals.
- Distinguish money raised for the company from shares sold by existing holders.
- Compare the IPO price with prices paid by earlier investors and with listed peers.
- Explain why heavy oversubscription does not make an IPO a good investment.
Builds on
- IPO basicsThat lesson explains how an IPO works.
- Comparing companies in the same sectorAn IPO is valued against listed peers, using the comparison method explained there.
On this page
In simple terms
An IPO is the first time a company's shares are offered to the public, as the IPO basics lesson explains. It comes with a long offer document full of information, and with a lot of excitement. The aim of evaluation is to use the first and resist the second.
The offer document
Companies file a draft offer document with SEBI, then a red herring prospectus with the price band before the issue opens. It is long, but a few sections carry most of the value:
| Section | What to look for |
|---|---|
| Risk factors | The company's own list of what could go wrong; read all of it, not just the first page |
| Objects of the issue | What the fresh money will be used for |
| Offer structure | How much is a fresh issue and how much an offer for sale, and who is selling |
| Basis for the issue price | The company's own comparison with listed peers, and prices paid in recent share transactions |
| Financial information | Several years of restated statements |
| Outstanding litigation | Cases against the company, promoters and directors |
| Related-party transactions | Dealings with entities linked to promoters |
| Promoters and management | Background, other businesses and holdings |
Offer documents are available on the SEBI, exchange and lead manager websites.
Fresh issue or offer for sale?
- A fresh issue creates new shares; the money goes to the company, for uses stated in the objects of the issue.
- An offer for sale lets existing shareholders, such as promoters or private equity investors, sell their shares; the money goes to them, not the company.
Neither is bad in itself. But when most of an IPO is an offer for sale, ask why the sellers want to sell now, at this price. For a fresh issue, check whether the money will fund growth, repay debt, or simply go to "general corporate purposes".
What did earlier investors pay?
Offer documents disclose the prices at which shares changed hands before the IPO, including the average cost of the selling shareholders.
Worked example: A made-up IPO
| Item | Detail |
|---|---|
| IPO price | ₹400 per share |
| Price paid by the selling investor 18 months earlier | ₹150 per share |
| P/E at the IPO price, on the latest year's earnings | 60 |
| P/E range of listed peers | 35 to 45 |
| Subscription | 80 times |
The seller is making well over twice their money in 18 months, and new investors are paying a higher multiple than listed peers, as the comparing companies lesson explains. That is only acceptable if the company is clearly better than those peers.
Timing and incentives
Sellers and their bankers choose when to launch an IPO, and they tend to choose strong markets, when investors will pay the highest prices. Recent profits may also be at their best just before an IPO. This does not make every IPO bad, but it means IPOs are generally priced to suit the sellers.
Oversubscription is not value
Headlines about an IPO being subscribed many times over measure demand, not value. Demand can come from investors hoping for a quick listing gain, a crowded market, or the herding the earlier lesson describes. Heavily oversubscribed IPOs have sometimes listed below their issue price or fallen later, as the business or market disappointed.
A short process
- Read the risk factors, objects, offer structure and related-party sections.
- Build a table of the restated financials and check profit against cash flow.
- Compare valuation with listed peers and with recent pre-IPO prices.
- Ask why the sellers are selling now.
- Decide whether you would buy the company at this price if it were already listed.
Why it matters
IPOs are promoted heavily, often at the moment when markets are most optimistic. A careful reading of the offer document gives you far more information than the advertisements and lets you judge the offer as you would any listed share.
Limitations
New listings have short public histories. Restated financials may flatter recent years. Peers may be few or imperfect. Short-term listing moves can be driven by sentiment unrelated to value.
Common mistakes
- Applying because of oversubscription or grey-market chatter.
- Ignoring the offer for sale and who is selling.
- Skipping the risk factors.
- Comparing valuations only with expensive peers.
Try it yourself
- Download the red herring prospectus of a recent IPO.
- Note the split between fresh issue and offer for sale, and who is selling.
- Find the prices paid in recent pre-IPO transactions and compare them with the IPO price.
- Compare its valuation with three listed peers, and write whether you would buy it at that price if it were already listed.
Key takeaways
- The offer document, called the red herring prospectus before the price is fixed, is the main source. Read the risk factors, the objects of the issue, the financial statements, litigation and related-party sections.
- A fresh issue raises money for the company; an offer for sale lets existing shareholders sell. A large offer for sale means the main purpose is for existing holders to cash out.
- Compare the IPO price with what earlier investors paid recently, and with the valuations of listed peers.
- Sellers choose when to sell, often in strong markets, so IPOs are usually priced to suit the sellers.
- Heavy oversubscription measures demand, not value. Listing gains are not guaranteed, and longer-term returns depend on the business and the price paid.
Check your understanding
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Terms used in this lesson
- IPO
- An initial public offering, a company's first sale of shares to the general public, after which its shares are listed on an exchange.
- Offer for sale
- The part of a share sale in which existing shareholders sell their own shares to the public, so the money goes to them, not the company.
- Red herring prospectus
- The offer document for an IPO, filed before the final price is fixed, setting out the business, risks, financials, the use of proceeds and who is selling.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.