IPOs are running hot ahead of new wave of listings before one-year validity of approvals from the Securities and Exchange Board of India (Sebi) for several companies expire. Since IPO-bound businesses do not have a track record of exchange disclosures or trading history, investors rely on what the companies disclose before listing, primarily through the red herring prospectus (RHP).
A closer look at a handful of sections of this lengthy, technical document can help investors spot , assess company’s financial quality and valuation. Investors must look for the following warning signs before placing their bet to dodge lemons.
Beware of these 10 warning signs before investing
- Complete Circle Capital vice-president and partner Aditya Kondawar said, “If existing investors are simply using the IPO to exit, that may not augur well, because the basic premise is that the company should make productive use of the capital,” as reported by Mint.
- According to Aditya Kondawar, investors should study the prices at which shares changed hands in the months leading to the IPO. Implying that examination of shares is essential to assess the company’s financial quality, Kondawar added, “If an received shares at a particular price six months before the IPO and the issue is priced at twice that level, did something materially change in those six months to justify the increase?”
- Move beyond the latest period and evaluate employee and marketing costs of companies issuing IPO over a period of several years. This will give a clearer picture of the company’s financials as businesses often pull back on advertising and staff costs before an IPO to make losses seem minimal or move closer to break-even, Kondawar pointed out.
- Segregate short-term from long-term debt as heavy dependence on short-term borrowing can be a sign of working-capital stress, Kondawar advised.
- Anand Rathi Shares and Stock Brokers head of fundamental research–investment services Narendra Solanki suggested that investors should evaluate “what fundraising took place shortly before the IPO, at what valuation and under what ”. The details are available in the RHP.
- Another warning sign about which Solanki warned is compensation of promoter and top-management. These should be assessed in accordance with industry standards. Besides this, contingent liabilities disclosed in RHP should not be overlooked as a large figure relative to net worth could leave the balance sheet weaker than it appears if those claims crystallize.
Notably, contingent liabilities include guarantees issued on behalf of others, disputed tax demands, pending legal claims and discounted bills. These represent potential obligations that are not recorded as debt on the balance sheet but could materialise as liabilities in the future.
- Head of retail research at ICICI Direct head of retail research Pankaj Pandey cautioned against company’s promoters with a history of frequent business changes or large related-party dealings. He also advised investors to examine auditor remarks indicating weak internal controls. “The RHP discloses information about the promoters, their track record, related-party transactions and any pending litigation,” Pankaj Pandey said.
- Pointing to another alarm bell, Pankaj Pandey said. said, “If the company shows profits on paper but negative cash flows year after year, that is a red flag.”
- Carefully examine financial statements to spot over-dependence on one or two customers or suppliers which is a warning sign.
- Repeated equity issuance is a major cause of concern as it can dilute existing shareholders.