Breaking down to the IPO process
In the previous lesson, we briefly covered how Raj took his company to the BSE and is looking to IPO his company. If you recall, we talked about how investors first get access to the shares Raj issues through the IPO. We’re ...
Breaking down to the IPO process
In the previous lesson, we briefly covered how Raj took his company to the BSE and is looking to IPO his company. If you recall, we talked about how investors first get access to the shares Raj issues through the IPO. We’re going to dig a little deeper into this process in this lesson. This step is important because it determines what price the stock actually gets sold at.
Alright, so there are five basic steps from the second Raj wants to take his company to the public to it actually being listed on the Bombay Stock Exchange. The five steps are:
— Raj needs to find and appoint an investment banker(s).
— Raj needs to apply to SEBI with a registration statement.
— Raj needs to file a fancy document called a “Red Herring Prospectus”.
— Raj needs to advertise his IPO.
— Raj needs his investment bank to evaluate his business and fix “price bands.
So let’s go through these one by one.
Step 1. Finding and appointing an investment banker
The first step for Raj is to find an investment bank. Think of your major banks, like ICICI, Kotak, IDBI, SBI, etc. They each have investment banking divisions. Raj picks one, pays a fee, and their job from that point onward is to help Raj to take his firm public.
Step 2 : Applying to SEBI with a registration statement.
As you already know, SEBI is the market regulator, so Raj needs to file a basic registration statement with SEBI indicating that he’s looking to list his company on the Bombay Stock Exchange. In due time, he will get SEBI’s nod of approval. Its job is “to protect the interests of investors in securities and to promote the development of, and to regulate the securities markets.”
Step 3: Filing the “Red Herring Prospectus
Next, we go on to the Red Herring Prospectus. Here’s what it looks like:
So what is the Red Herring Prospectus? As intimidating (and odd) as the name might sound, it’s really not. This simple document contains important information about Raj’s Sweets Pvt Ltd. For example, what is the size of the IPO? What’s the company’s history? Is the company in debt, or is it financially stable? What are its future plans?
In a nutshell- the Red Herring Prospectus contains everything an investor would want to know. Imagine you were an investor looking to buy shares of Raj’s Sweets, wouldn’t you want to know every single detail about the company? That is why all this documentation is required.
You will notice that the draft has three investment banks mentioned in the bottom. Those are the investment banks involved with the deal. We’ll get to that in a bit.
Step 4: Advertising and Marketing Raj’s Sweets
Raj’s sweet is advertising like crazy. It’s on the newspaper, magazines and even on TV. This improves public perception and helps to create a buzz in the market. It basically helps in the better listing price on the NSE and BSE when it lists.
Remember when JustDial went IPO in 2013, or when Twitter and Facebook went IPO in the US? A lot of marketing went behind those news releases. Raj wants that type of hype, and so his PR agency and investment bank take care of the work. He conducts interviews and portrays his company as a must buy company.
Quickly, word out that the company that produces the best sweets in Mumbai is going public!
Stock Split Issue
Stock splits happen very often in the stock market. You must have heard about big companies offering a stock split.
The investment bankers felt that Rs. 7,165 per share is just too high. Think about it: if an average retail investor wants to buy just 10 shares of his company, he needs to fork out more than Rs. 70,000! Fortunately, there’s a silver lining: We can issue a stock split.
For example, we can issue a 10:1 stock split. We know that there are 150 shares in the company, and we were looking to issue shares to the public at a price of Rs. 7,165 per share. Therefore, the entire company on paper (called the book value) is worth Rs. 10,74,802.
By simply increasing the number of shares tenfold; that is, from 150 to 1500 shares and by dividing the price by 10, from Rs. 7,165 to Rs. 716.5, the company is still valued at Rs. 10,74,802 (150 x Rs. 7,165). Therefore, nothing changes on paper.
But the key element is that the perception changes. Most stocks listed on the BSE are priced at Rs. 1000 or below, so to price it at Rs. 7,165 from the beginning would be unusual.
And so Raj agrees to the stock split. Raj Sweets now has 1500 shares outstanding, and each share now has a book value of Rs. 716.5. Stock splits happen regularly and it is usually done to increase the number of shares in the market and to make it easier for smaller investors to participate and purchase shares as well. Keep in mind that since we have issued a 10:1 split, Raj is now issuing 200 shares to the public through the IPO instead of 20.
Pricing the stock
So at this point Raj is content. He’s issued a stock split, his investment bankers are doing their job, and he’s waiting patiently.
What is he waiting for? If you recall, we used the term “book value” earlier. Raj wants to price the stock at Rs. 716.5 per share based on the company’s current earnings. But what about future earnings? He’s looking to expand his business, and based on the Red Herring Prospectus, investors can see that earnings from the future- that is, future earnings- are expected to be much higher than his company’s current earnings.
Imagine you’re a potential investor and read through the Red Herring Prospectus. You do all the homework and realize that this is a company on the verge of expanding like crazy! You take all the information the document has on Raj’s company, and use a methodology called Discounted cash flows to discount future revenues and costs. You take in account the fact that Raj’s company is expected to earn a lot more going into the future; and that information needs to be priced into the stock now. And when you do your calculations, you realize that the company is worth Rs. 1500/per share, instead of Rs. 716.5, right now!
So would you be willing to pay more than Rs. 716.5 per share to own a part of this company right now? Of course you would!
Step 5-Price Band
And just like you, the investment bank does the same homework- but more diligently. They know there are hundreds, perhaps thousands, of investors just like you. And so what they do is fix a price band. In order to ensure that people actually bid on the stock, they fix a price band between Rs. 950- Rs. 1000.
Now, the public, including you, can bid on Raj Sweets.
The bidding process is not exactly the simplest process in the world. There are different types of investors who are looking to bid on Raj’s Sweets. You have institutional buyers- these are basically companies that pool together large sums of money. These include mutual funds, hedge funds, and pension funds- basically, large funds that are structured as companies. You also have HNI’s- that is, High Net worth Individuals- who might have an advantage by banking directly with the investments banks involved in the deal. Finally, you have people like you- the retail investor.
All these players are looking to bid between the price bands of 950 and 1,000 per share. After the bidding is done, a final price is decided through a process called Price discovery which means people bidding between price bands. Depending on demand and supply will be able to find what will .Another point to note is that, when bidding for an IPO, you cannot just bid for one share; instead, one must bid for a minimum size of shares called a lot size.
Any retail investor can place a bid, and once again, from the convenience of their home. Investing in stocks is truly amazing, isn’t it?
You just saw me place a bid on an IPO. Isn’t that pretty neat?
There is no limit to how many bids can get placed. Raj is looking to issue 200 shares to the public- but the bids are flowing in, and we have received 1000 bids!
At this point, what the investment bank will most likely do is issue the shares at the highest price- that is, Rs. 1000 per share. Because of the oversubscription, not all bidders will get their hands on the IPO. The investment banks will boast that the IPO was oversubscribed 5 times. This creates excitement in the air.
When Facebook went IPO, its price bands were set at between $28 and $35 per share. Facebook was looking to raise $10.6 billion US Dollar by issuing 337 million shares to the public. It turns out that despite the huge amount the firm was looking to raise and the enormous number of shares, it was oversubscribed 5 times as well.
Primary versus Secondary Markets
Each day, companies get IPO’d. Many times, investors falsely assume that when they are buying shares, they are buying them directly from the company.
That is actually WRONG!
Let’s go back to Raj example. Remember he was releasing 200 shares to the public, that IPO is a onetime event; it happen only once and hence called Primary market. The primary market is the IPO and after the allotment has taken place, it lists on the stock exchange like NSE or BSE. Then when trading happens between people or traders and that is the movement you hear every day. This is called the Secondary market. So remember, when you hear the stock going up and down on daily basis that is between people. The demand and supply of people gives us an idea whether the stock is going up or down.
Valuing a Stock
Alright, so we’ve gone through the entire IPO process. You know the difference between primary markets and secondary markets.
But we still haven’t answered the most basic of all questions: how do we know if a stock is underpriced or overpriced? To put it more clearly, when should we buy a stock?
Price to Earnings Ratios
One of the most basic ways to understand how a stock gets priced is by looking at its Price to Earnings Ratio, or P/E multiple as it is commonly referred to. The accurate calculation is to divide the stock’s current share price by its earnings per share (EPS). Usually, the EPS is based on the earnings for the past 12 months of a company.
Let’s go back to Raj’s Sweets. If you recall, we went through the hypothetical case of what an investor would be willing to pay for one share of stock. Let’s go back to Raj, his company’s book value listed the price per share as Rs. 716.5 based on the company’s current performance, when an investor looks at the Red Herring Prospectus and realizes that the price of the stock should be higher based on higher future earnings, he discounts the future cash flows and comes to a higher price than 716.5. In other words, he is willing to pay more than 716.5 per share.
The multiple that investors are willing to pay more than 716.5 is the P/E of the stock.
Simply put: A stock with a high P/E usually signifies high expected revenues and earnings in the future. An extreme case can be a company that has zero earnings with a high P/E multiple. (for example, imagine a company that is not profitable but is expected to grow exponentially and earn enormous profits over the next few years).
The reverse can also be the case: there are stocks with P/E ratios less than 1! In essence, investors are pricing the stock so low that the future revenues and earnings is essentially negative, so that when it gets added to the company’s current earnings- it lowers its valuation!
And so, unless you’re an accomplished analyst, it’s going to be difficult to determine whether a stock is a good buy purely based on its P/E multiple. One general indicator is to compare a stock versus its peers within a sector. Suppose Raj Sweets has direct competitors listed on the BSE, and their P/E multiples are in the 5-10 range. If Raj’s Sweet’s has a P/E of 3, it might be an indication that it is underpriced!
But that being said, P/E’s can be quite absurd at times. Just take a quick glance of stocks with the highest P/E ratios on the NSE, and the lowest P/E ratios on the NSE.
How do you possibly make a decision on whether or not trade a stock with a P/E of 2743, or a P/E or 0.2?
That’s why a proper methodology is critical towards developing your strategy.
There are two basic schools of thought when it comes to how and when to select stocks to invest and trade: fundamental analysis, which uses financials (such as P/E ratios) to figure out the true value of stocks; and Technical Analysis, which analyzes the market psychology through price charts.
In the next lesson, we will equip you with the basics you need to finally get started with trading stocks. Questions such as which broker to trade through, different order types, and common mistakes to avoid will be covered. We will end the lesson by going through the trading methodologies of 5 legendary traders/investors, showing how each differs from the others in order to guide you towards a methodology that suits your style.