How exactly is an IPO price decided?

I received a query from my friend and reader Ranjit. He has seen lots of IPO coming into the market and is unsure which ones are good and wants to understand this process of fixing the price so as to be able to make an informed decision.

Methodology
The process of deciding IPO price is generally done by what is known as ‘Book building process’.

Firstly the number of shares to be issued is decided and merchant bankers with book running lead manager appointed.These guys manage the whole show until the company is listed. The lower price end is known as the floor price and investors are expected to at least meet that price in order to make a valid application. Floor price is decided based on various factors like comparison with industry peers, past financial statements, track record of promoters and market sentiment etc. It is in the interest of the company to keep this price rational because if it’s too high investors may not bid for the issue and book building process will fail. This happened to companies like Wockhardt Hospitals,Emmar MGF etc.. The higher end of the range is maximum about 1.2 times the floor price this gives us the price range.

Investors now bid for number as well as price and the highest price(within the range) at which the complete book can be sold is decided as final issue price. For example
Assume that the range is Rs 100 – 120, and only 80% of book can be done at 120 then the price is lowered to the price at which 100% of the shares can be sold. Investors who bid at a higher price are sold at a decided price and refunded the difference and investors who bid lower than the decided price are not allotted any shares and refunded completely.

Reliance Power was an example of a well marketed IPO, the company sold shares without any earnings from operations at the price of about 5 digit P/E and this left a bad taste in the mouth of investors when shares dropped below issue price. The company was forced to give a rights issue to pacify investors since the promoter does not want his reputation to be hurt. Once investor sentiment is hurt it’s very difficult for the company to raise money from the market again.IPO listed when market sentiment was at its peak and people were willing to pay really high prices for stocks but ultimately the market will fall in line with value regardless of marketing gimmicks.

Coal India IPO was an example of well priced IPO this generated lot of interest and made money for the investors. Market respects good companies offered at fair prices. As a investor we must always try to read the ‘red-herring’ prospectus. This contains info about rational for deciding the price and describes the business of the company etc. We should carefully do an evaluation based on quantitative and qualitative factors.

So why do IPO’s fail sometimes?

Promoter’s short term greed is usually the key factor. If a new company comes into the market its price has to be rationally comparable to other listed companies in the same space. If an issue list during situation when market sentiment is driving risk aversion among investors even good issues may not get the attention they deserve.

However once a company lists and begins to perform more people will line up to buy at higher prices thus pushing the price up and making the promoter rich in the process (assuming he is the majority share holder) however we live in a world dominated with fast –foods but junk food does come back to bite you and so will the mis priced IPO.

SKS IPO

While investing in a IPO always try to go through the red-herring to understand the financials and risks.Usually IPO's are dressed up for sale so I avoid them unless the logic is compelling. Had a look at SKS, its india's biggest micro- finance company as per its current loan book.(about 3000 crore loans outstanding)
Positives
1. Expertise in micro finance.
2. Company seems to be sound and growing fast, over 100% CAGR
3. Business logic is strong (rural growth) and high asset quality(low NPA.)
4. Backed by savvy personalities like Soros and Narayana morthy (Infy)

Negatives
1. High valuations. Over 5 to 6 times BV
2. Business will be debt heavy and will need capital infusion periodically (dilute returns)
3. The company will need to charge high interest rate from borrowers because it does not issue long term loans.

Opinion:
I would avoid it unless playing for listing gains which are likely because there is no other listed NBFC in micro-finance space. The valuations are high( its being offered at 3 times the cost to pre-ipo investors) but market loves novelty and ‘x’ factor is boosted by high profile names attached to the company

India's oil price confusion

I have been reading up and trying better understand oil and gas sector. I found this good article on ' Macro sensitivity of oil prices' by Morgan Stanley on india's oil price confusion.Its interesting to see that multiple taxes are linked to the oil price so actually India's oil price confusion is actually a tax problem.Enjoy the read !

Portfolio health check

We all periodically go to a dentist/general practitioner to validate our well being, also check our credit card statement to make sure they make sense- why should investing be any different ?!

As an investor we need to periodically do a 'health check' for the stocks we hold. If the health has got better we have an excuse to hold/add, If the patient needs medication -are the management up to it? .I mean that just holding the stock without any reason for doing so will not help your portfolio, also helps us to look back at our decisions and review the factors which made us to invest in first place.

Few points to check:
• Is the original investment logic still valid.
• Is the company generating adequate cash flow.
• Is the company is getting into areas which are unrelated diversification and reducing focus.
• Are the managers allocating capital rationally.
• Debt and tax levels.
• Profitability (ROE,ROIC) is it reducing/improving.
• Is the stock is valued much more that the business is worth..

You may have your own checklist but it has to based on price vs. value equation in mind. As Warren says -In investing, just as in baseball, to put runs on the scoreboard, one must watch the playing field, not the scoreboard.

Investment Idea: Zen Technologies

Business: Zen is 16 yr old company, primarily into simulation space for Police, Army, Navy so its sort of defense sector play. They like to call themselves as a ‘System Engineering’ company having skills in mechanical, software and electronics.

It’s important not to confuse them with other companies who work on off shoring model, Zen invests heavily in R&D and skills so that they can be at the cutting edge of innovation They are setting up a subsidiary for making games for platforms like PS/3 etc, will be launching their first game by end of 2010. .

Moat: Low cost producer and familiarly with Indian procurement cycle and customer behavior. Any foreign company investing in defense sector needs have an offset cost. Not a great moat but building a brand takes time.

Competition: BEL (Bharat electronics) is partially into similar space however Zen is in niche sector.

Financials: The results reflect that the company has graduated to a higher sales and growth path last couple of years (prior years the sales growth was flat) they seem to have gained a critical mass to at least remain at this level. FY10 sales is about 52 crore, profits 16 crore, the results are flat to marginally lower as compared to last year. Debt is minimal and margins are high.

Risks: Threat from competition and due to over dependence on govt. orders earnings will be lumpy (fourth quarter bias)

So should you buy ?

This is a kind of stock you want to track and buy as the business improves, its hard to ‘load the truck’ considering lumpy results and evolving nature of the business. At Rs 190 and mcap of 180 crores is value for money as a small exposure.