An Initiation Into IPOs

Foreword from ShareInvestor

This article “An Initiation Into IPOs” by Mindy Tan was first published in The Straits Times on 19 Sep 2011 and is reproduced in this blog in its entirety.

MINDY TAN highlights some factors that investors should consider before buying into an IPO

Initial public offerings (IPOs) have recently been in the limelight, with brands commonly known in popular culture and mass consumerism circles toying with the idea of going public. Groupon, LinkedIn, Manchester United, and closer to home, Sheng Siong, are some companies that come to mind when one considers the more popular names that are considering or have since launched their IPOs.

An IPO, which is essentially the first sale of equity by a private company to the public, is often issued by companies seeking capital, in most cases, to expand. Beyond looking at brand significance, or themes such as energy and China, here are some factors that investors should consider:

Financial Performance

According to Lee Kin Wai, assistant professor at Nanyang Technological University’s business school, a company’s financial performance is one of the most important factors investors should look at when considering an IPO.

“Typically, this entails evaluating the company’s profitability (such as return on assets, profit margin, and return on equity), liquidity position (such as cash flow generation, current ratio, and quick ratio), solvency risk (such as debt-to-equity ratio and interest coverage), and operational efficiency (such as receivables turnover, inventory turnover, and fixed assets turnover),” says Prof Lee.

“Investors should benchmark the financial performance of the company against historical trends and comparable firms in the same industry to obtain a better understanding of the overall financial condition of the company,” he adds.

What Will The Proceeds Be Used For?

What proportion of proceeds is being used to repay term loans, finance daily operations of the company or finance expansion plans?

Would you rather invest in a company that needs to obtain money from the public to keep its daily operations running or a company that is able to cover these expenses by cash generated internally?

Says Prof Lee: “Of course, investors should be concerned if a large percentage of the IPO proceeds is allocated to reduce debt as this indicates a high probability of expected wealth transfer from equity holders to debt holders.

“That said, if debt is reduced, the company may benefit by having greater flexibility in its operations via the relaxation of costly and tight debt covenants or restrictions.”

Pricing

According to Prof Lee, IPOs tend to be underpriced (ie the first-day listing price is, on average, higher than the IPO price) to compensate investors for the information disadvantage, given the information asymmetry between corporate insiders and external investors.

“Indeed, the higher the information asymmetry, the greater the IPO underpricing because investors will usually demand price protection,” he notes.

“There is some recent empirical evidence indicating that IPO underpricing is inversely associated with the specificity of disclosure on the expected usage of IPO proceeds. In other words, IPO underpricing is less severe if there is more detailed and specific disclosure on the expected usage of the proceeds,” he says.

Dividend Or Yield?

In this regard, an investor’s preference is key. In times of volatile stock prices, many investors have tended to be partial to dividend- yielding stocks.

“If a firm with a low dividend payout invests the internal funds in value-adding projects, its stock price is likely to appreciate in the future. From this perspective, a low dividend payout may be substituted with high potential future capital gains,” says Prof Lee.

“Then again, given capital market frictions such as information asymmetry, a firm may use its dividend policy as a signaling mechanism.

“For example, a high dividend payout may signal management’s optimism in the firm’s future business performance. It indicates that future cash flows are expected to be high, at least sufficient to meet current dividend payouts. Companies generally try to avoid cutting dividends, as such action is viewed negatively by investors.”

Others Factors To Take Into Account

In addition, investors should also consider the company’s corporate governance structure, says Prof Lee. This includes the independence of the board of directors and the audit committee, management expertise, quality of external auditors, and presence of institutional shareholders.

Market Sentiment

Is now the right time to delve into stocks? Reports abound of the debt crisis in Europe and government budget deadlock in the US. But how does this affect companies?

Prof Lee says: “If share prices reflect the present value of expected future cash flows, then a decline in stock price reflects expectations of lower future cash flows or a higher risk premium.

“Possible factors leading to expectations of lower future cash flows include lower sales growth due to general business deterioration, higher potential bad debts from customers, and rising business costs.”

Indeed, companies with significant exposure to European and US markets are likely to experience downward pressure on profitability, he notes. Additional pressure also exists in the form of financing risks and higher cost of capital, especially if banks impose a higher risk premium on lending.

IPOs – Are They A Good Idea?

Investor Warren Buffett, once warned against investing in IPOs, arguing that “it’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors)”.

Regardless, IPOs have long attracted investors, whether drawn by the hype, or genuine bargain hunters convinced that the strong fundamentals portrayed by the company would sustain the stock.

As always, research is fundamental and as the Oracle of Omaha would no doubt say, always make sure you invest in industries you understand inside-out.