Biggest Mistakes to Avoid While Investing in an IPO

Data shows that thirty-five companies already came up with Initial Public Offerings (IPOs) so far this year. Of these, thirty-four companies were successful and managed to raise ₹26,945 crore from investors. Reports suggest that around 28 IPOs are scheduled for the second half of the current financial year (FY 2023-24). 

Usually, there is a spike in the number of IPOs and the funds raised when the markets are bullish. For example, the Indian stock market witnessed 63 IPOs raising ₹1,19,882 crores in the year 2021, when the markets started rising above pre-Covid levels, after staging a recovery. However, the IPO market lacked luster in 2022, as the markets mostly moved sideways. Around forty companies came up with their IPOs and raised ₹59,939 crores.

Investor frenzy was evident in high market participation and it came with its problems. A slew of retail investors wanted to make a quick profit and some of them found themselves in a soup. In this article, we shall look at some of the biggest mistakes to avoid while investing in an IPO.

What is an IPO, a.k.a. Initial Public Offering?

Companies require funds to do business. They initially get these funds from high-net-worth individuals, venture capitalists, private equity firms, and the like, by offering them a stake in the company. However, when they want to scale their business and require massive funds, they turn to the general public. 

An IPO is the process of raising funds or selling shares of a private company to the public by issuing stocks to them for the first time. After a successful Initial Public Offering(IPO), the company’s shares get listed on the stock exchanges and the general public can easily trade in them.

Biggest mistakes to avoid while investing in an IPO

Here are some of the biggest mistakes that one should avoid while investing in an IPO:

Applying through multiple Demat accounts

Sometimes, investors assume that applying through multiple Demat accounts will increase their chances of getting the allotment of the IPO that they have applied for, however, this is not true. If these Demat accounts are linked to the same Permanent Account Number (PAN), additional applications from multiple Demat accounts are not considered.

Not knowing why a company has come up with an IPO

If a stranger or even a known person, for that matter, asks you for some money, you would probably not lend it without asking them for a reason. 

When investing in a company’s IPO, it is important to know why it is raising funds. Companies usually come up with IPOs to raise funds for financing a new project, repaying loans, or for expanding their business. Sometimes they come up with IPOs to give an exit to their early investors. Sometimes, promoters might want to sell their stake in a company through an IPO. 

Not understanding the business

The biggest storyline driving investments in IPOs is the quick returns that one can make on the listing day. While there are stocks that have provided stellar returns, there are plenty of instances of stocks declining in value on their listing day. 

When a company is listed, a potential investor has very few sources to research about it. This includes the RHP, news reports, the general economic situation, and so on. However, quarterly and annual reports as well as management guidance are available from time to time, after it gets listed. These details are crucial to consider for remaining invested for the long term.

Driving with blindfolded eyes is sure to lead one to an accident. Similarly, investing in a company’s business without understanding its business model and fundamentals does not serve the purpose, irrespective of the hype surrounding it.

Blindly falling for the company’s name

Another big mistake that investors make, is blindly investing in a company because of its big brand name. Big brand names do not guarantee big returns. Well, if that were true, everyone would only invest in such companies and earn massive profits. There have been plenty of examples in the past when bigger brands did not lead to bigger returns, while lesser-known companies with strong business models helped investors make a fortune.

Inadequate research

The secret to identifying a good IPO for investment is to back it up with good research. This includes understanding the company’s business model, its products and services, its potential target markets, the industry that it functions in, its financial health, and the background of its promoters and management, among others. Thorough research helps one identify the pros and cons of investing in a business and make a rational investment decision.

Falling for a Valuation Trap

The valuation of an IPO is one of the most important quantitative parameters to assess. Until recently, the Securities and Exchange Board of India (SEBI’s) regulations permitted only profit-making companies with a pre-tax annual profit of at least ₹15 crores to get listed on the bourses. Later, it passed a caveat stating that institutional investors should hold 75% of their shares, opening doors for new-age tech companies. 

Many of these companies did not have listed peers for comparison, therefore, investors had to depend on unsubstantiated growth projections and market trends. A valuation trap occurs when investors believe that a stock is valued at a discount, but its valuation might be low due to poor financials, the cyclical nature of its business, loss of market share, poor strategic direction, and the like. They might end up paying more for what they get.

Basing Decisions On Subscription Data

News about marquee investors and HNIs investing in a company just before its IPO creates subscription hype. It makes investors believe that big players are interested in the IPO, no matter how inadequate and rumour-filled it might be. 

At this point, they do not know if these players actually bought the shares or not, or their intentions post the IPO. These investors might sell their stake in the company after its IPO, leading to a drop in its share price, at least in the short term.

Ignoring the Red Herring Prospectus

Many articles and videos available on the internet claim that they have covered details related to an IPO comprehensively. However, that may or may not be the case. It is important to read the Red Herring Prospectus (RHP) before investing in a company. This document contains some of the vital details related to the business, promoters, sources of funds, dividends, major partners and so on. 

The RHP can be critical to one’s decision to invest in an IPO. Even if one cannot read it page by page, it is important to go through the highlights before making an investment decision.

Lack of information and investment goals

IPO investments are to be treated similar to other investments that one makes in their overall portfolio. Lack of information is one of the biggest mistakes that one can make while investing in an IPO. 

Therefore, it is important to gather as much information as possible from multiple sources before investing. Moreover, it is important to determine one’s goals, investment horizon, and risk appetite before investing.

In Closing

Investing in an IPO can be a great opportunity to make profits, however, it is important to avoid mistakes that can limit overall returns. Investors can make well-informed decisions by researching the company’s business model, fundamentals, and valuation and by gathering as much information as possible before investing. It is important to be careful about the hype that an IPO creates in the market and make a thought-through investment decision.

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