Money Plants

Friday, March 10, 2006

Whys, Whats and Hows about IPOs

I think a post on IPOs has been long overdue now. So here goes. Let me take this step by step.

Why does a company issue an IPO?
A company issues an IPO to raise funds in the form of equity capital. Equity capital is a cheap source of funds for the company because there is no obligation to pay back interest or principal as is in case of bank borrowings.

How is the issue procedure?
A company approaches a merchant banker to handle the entire issue. It tells the banker that it wants to raise a certain amount of money from the market. The banker then assesses the value of the company based on its assets, liabilities, future potential etc and arrives at the number of shares the company should issue and at what price or price band.

What is price band?
Here let me introduce the concept of book building. Till a few years ago (say 4-5 years ago) there was no such system as book building being followed. A merchant banker would assess the value of the company and announce the issue price at a fixed amount. Investors could buy the issue at that given price.

However, due to the dynamic nature of the stock markets today, there is no fixed issue price. Instead, the merchant bankers announce a price band or price range which they believe is the ideal range for an issue. Subsequently, investors would send in their bid for the price within that range. Once all the bids have come in, a price 'discovery' happens wherein the lead banker will assess the various bids, quality of bids and decide which price would be most investor friendly (that is, at which price he can keep most investors happy). It need not always be investor friendly, as a company may decide to price it higher in anticipation of demand. The issue price is then fixed at that price.

What next?
After the price is fixed, allotments are made to applications at that price. For those who don't get an allotment, a refund is made. A few days after allotment, the issue is listed in the stock exchange.

What is listing price?
Listing price is the price at which the first trade in the share is done on a stock exchange. The listing price is a function of demand and supply. If there are more buyers than sellers for that share when the stock market opens on the day of listing, the price will be higher than issue price. If there are more sellers than buyers, the price will fall below issue price. Usually, in a bull run, listing prices are often more than issue prices, but that is not a rule.

Through the day, several trades take place which decide the price at which demand and supply meet. It shows how much a buyer is willing to pay for a share and how much a seller expects to make. Thereafter, it's like any other share in the market.

How to go about investing in IPOs? Can I always purchase enough shares in an IPO to my liking?
Retail investors, HNIs and Institutional Investors have separate quotas in an issue. A retail investor should apply through the retail quota and you need to have a demat account. A retail investor has an option to either apply at a price (within the band) or at a cut-off. If you apply at a price and the issue price is decided at a higher price, you don't get any shares. If you apply for cut-off, it means you are ready to buy at any price.

You will not always get enough shares as you applied for. If the issue is oversubscribed, you get shares proportionately or pro rata as it is called.

Is it a good option viz-a-viz a regular share?
Cost-wise there really is no difference. While buying a normal share, you pay buying commission to your broker. While you dont bear this cost directly while buying in an IPO, the cost gets factored into your issue price because the company will bear it and pass it on.

Whether an IPO is a good investment really depends on the quality of the issue. It matters even more in a bull market. The share may list very well because of people who want to make money on listing, but if its not an inherently good scrip, the price will fall eventually. You need to do a lot of homework about the company and consult an expert before investing.

10 Comments:

  • hey money gardener
    thatz yet another interestin post..i have couple of qns to ask
    1. What is dutch auction and french auction? How is book building process connected to these two?
    2. If google adopted dutch auction for its IPO, what was it that made it so notorious?
    3. This is regarding fixed rate bank loans. I understand that these fixed rate bank loans are connected to the bank's PLR and hence subject to revision whenever the bank increases/decreases the PLR. If this is correct what is the exact difference in frequency bw fixed and floating rate? Also by negotiation is it possible to a get a fixed rate loan throughout my loan tenure say 15 yrs? If this is true, assuming i have taken a loan some 3 yrs ago at a fixed-tenure rate of 6.5% for 15yrs, so now when the current market rate is 9.5% the bank is losing so much of money. So why should they do that??

    Y dont u write a post on bank loans? Expecting to hear from you..

    Divya

    By Anonymous Anonymous, at 1:12 AM  

  • Hi Divya,
    I have made a post on home loans. Check this link:
    http://moneyplants.blogspot.com/2006/02/truth-about-home-loans.html

    1) I understand that these fixed rate bank loans are connected to the bank's PLR and hence subject to revision whenever the bank increases/decreases the PLR.
    ---You mean floating rate loans. Fixed rate means just that - fixed thru the tenure.

    2) What is the exact difference in frequency bw fixed and floating rate
    ---Varies from bank to banks and also depending on what they want to sell. If they do not want to sell fixed rate loans, the premium would be far higher than a floating rate loan, which is what is happening now in India.

    3) Also by negotiation is it possible to a get a fixed rate loan throughout my loan tenure say 15 yrs?
    ---Yes, depending on market forces

    4)If this is true, assuming i have taken a loan some 3 yrs ago at a fixed-tenure rate of 6.5% for 15yrs, so now when the current market rate is 9.5% the bank is losing so much of money. So why should they do that??
    ---When they gave you the loan at 6.5% 3 years ago, they also raised cheap long-term funds (maybe at 6%) at that time. Hence their spread or margin remains intact.

    Remember that the cost of source of funds also decides interest rates on loans.


    Will come back on the auctions bit later.

    Rgds,
    MG

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