Making an investment through the form of an Initial Public Offering (IPO) is one of the most thrilling options for both experienced and novice investors. It gives investors the opportunity to become a shareholder of an organization prior to it entering the market. Many investors are attracted to IPOs because of the possibility of earning large profits on listing day or a long-term financial gain and, sometimes these hopes become reality. However, the reality is often the opposite tale.
While a few IPOs prove to be multi-baggers that yield impressive returns over time, other IPOs don’t perform to the standards of their advertising. It’s common for companies to launch with a premium price and then see them plummet after their initial public offering. This kind of unpredictability is the reason researching before making a decision to invest on an IPO is essential and a financial analysis is at the center of the preparation.
Why You Shouldn’t Rely on IPO Hype?
The majority of IPOs have a lot of media and marketing hype. There’s excitement, large subscription rates and grey market premiums and most often, fear of being left out (FOMO). However, relying on only news or the grey market’s trends can result in poor investing decision-making. To know if an investment is worthwhile in, it is essential to examine past the news headlines and look at the company’s fundamental financials.
In this comprehensive guide, we’ll breakdown the most crucial financial ratios that every IPO investor should be looking at. From profitability indicators such as the EPS or ROE to ratios of balance sheet like debt-to-equity ratio and current ratio, we’ll explain how each ratio operates and what it can tell you about it, and how you can use it to evaluate upcoming IPOs.
If you’re looking to file the first IPO or want to improve you investment-related skills, this article is the perfect place to start.
Let’s get started and discover how to distinguish the good IPOs from the ones that risk a lot of money -by using simple, but effective Financial ratios.
Read :
Top 10 Largest IPO’s in the world till date
What Factors make the IPO biggest ?
Top 10 Financial Ratios to Check Before Applying for an IPO
Earnings Per Share (EPS) :
Earnings per Share (EPS) is one of the most frequently utilized financial indicators in the realm of investing, and with an excellent reason. It provides an understanding of the profits a business earns for each share it owns. In a nutshell it reveals how profitable the business is on an individual basis and makes it simpler to evaluate between different companies, regardless of size.
The EPS calculation is based on the formula:
EPS = Net Profit / Total Number of Outstanding Shares
This number will help you determine what amount the business has earned per share you, as an investor, could hold following making an application for an IPO. A higher EPS generally suggests greater performance and a lower or negative EPS could indicate that the business has difficulty generating profits.
Keep in mind that a higher EBITDA doesn’t necessarily mean the company is a good investment, especially in the event of an IPO scenario. You must dig deeper to understand what is driving these earnings and if they’re sustainable over time.
How to Interpret EPS for IPOs?
In assessing the potential of an IPO, check the EPS listed on the Draft Red Herring Prospectus (DRHP) — usually in the section called “Financial Information” or “Key Performance Indicators.”
Here’s what to look out for:
The steady growth in earnings per share in the last two years indicates that the company is growing profitably.
The sudden spikes in the EPS prior to the IPO could indicate window dressing -temporary increases to make financials appear more appealing.
If the EPS is fluctuating or decreasing this could indicate that the business is struggling with an instability in its structure or market conditions.
Additionally, be aware that the EPS is calculated on standalone or consolidated results as well as whether it’s calculated prior to or after extraordinary events in these cases, since these elements can have a significant impact.
Compare to Competitors or the Industry Average :
The EPS of a company on its own doesn’t provide the complete picture. It is important to look at it alongside similar businesses in the same field.
For instance:
If a fintech company that is going to the public market has an earnings per share of 12 and its nearest competitors that are listed on the stock exchange have an average earnings of Rs18 It might indicate that the IPO company is still progress to make in terms of profit.
However If the EPS is greater than the industry standard it could be an indication of an efficient operation or a solid market position.
But EPS must not be your sole measure that you decide on. A company may have great earnings but also have bad cash flow, both of which are equally important factors to take into account.
Price-to-Earnings Ratio (P/E Ratio):
It is the P/E Ratio often referred to in the form of P/E Ratio is among the most commonly used measures to assess the value of a company particularly in the market for stocks. It reveals how much investors will pay for every dollar of the company’s earnings.
In the case of IPOs The P/E ratio is an vital part in determining if the issue is fair priced or undervalued, or even overpriced. Understanding how it functions can help you determine what IPO you’re considering is a good investment or better to leave it alone.
Formula and Interpretation:
The fundamental formula for The P/E Ratio can be described as:
P/E Ratio = Price per Share / Earnings Per Share (EPS)
For IPOs it is the “Market Price per Share” is the cost of IPO and the EPS will typically be calculated from the most recent financial year, which can be in a standalone or consolidated form (as described in DRHP).
Let’s say that an IPO has a price of 300 per share and the EPS is 10. Then:
P/E = $300 / $10 = 30x
The investors are requested to pay 30 $s for each $ 1 of profits the company made in the preceding year.
Significance in IPO Pricing :
The ratio of P/E is important as it allows you to determine whether the IPO is being evaluated:
A excessively high P/E implies that the company is being marketed to investors in a way that it’s not. This could be a good thing (if the company has solid prospective growth) or it could be risky (if that price has been inflated beyond realistic expectations).
A lower P/E might suggest a more conservative valuation that could lead to greater listing gains however, it could also be a red signal in the event that the company is not the competitive edge or potential growth.
In the IPO process, companies typically measure their P/E ratio in comparison to peers that are listed in the same field. This helps investors determine what the IPO is priced reasonably or not.
For instance:
If the average industry P/E ratio is 20x and an IPO has a price of 35x you must examine the factors that make the company worth the investment whether it’s higher margins, a stronger brand or simply marketing hype?
Red Flags: Extremely High or Low P/E
Although the P/E ratio can be an extremely useful tool, it must be used with care. Here are some warning signs to be aware of:
Extremely High P/E :
May suggest overvaluation.
This could be due to the hype, not by the actual power of earnings.
It indicates that investors pay an amount to secure future growth, which could or might not happen.
Example: A company that has no steady profits, but a P/E of 1.0or more is an speculation bet.
Extremely Low P/E :
It may appear attractive at first glance However, it could also mean:
The company is in a declining and highly competitive field.
The risks that are not visible within this business strategy.
Profits from one time are inflated by EPS and make the P/E appear to be lower than it actually is.
Always take a look at the the quality of earnings and not just the numbers. Also, verify if the P/E calculation is based on the trailing EPS (past income) as well as the forward estimate of earnings (projected income) in order to have a significant impact on the interpretation.
Return on Equity (ROE) :
Return on Equity (ROE) is a important metric of profitability that shows how well a company utilizes shareholders’ equity to create profits. In the case of IPO shareholders, ROE is a strong gauge of a company’s capability to generate profits on capital you have invested.
Why ROE Matters for Shareholder Returns :
ROE is the measure of the amount earned for each rupee of equity that shareholders invest. It measures the effectiveness of management in the use of capital to create profits. A greater ROE generally suggests that the company uses the money of investors efficiently to create value.
ROE = Net Profit / Shareholder’s Equity
In IPOs in which you’re about becoming a shareholder, ROE serves as an prior to listing report card about how the company has traditionally given shareholders with equity.
What a Healthy ROE Looks Like ?
The definition of a “healthy” ROE varies by the industry and industry, but generally anything that is above 15 percent is considered healthy. For companies that require less capital (like IT or FMCG) as high as 20-30% is feasible. For industries that require capital, such as infrastructure or manufacturing, ROE tends to be lower, and that’s fine so long that it’s not inconsistent.
What’s more important is an ongoing improvement and sustainability of ROE instead of single-time spikes.
ROE Trends Over Past 3 Years :
Before submitting an application for an IPO be sure to check the ROE has changed in the past two years (data accessible within the DRHP):
Continuous or increasing ROE is a positive indicator of a well-run capital management
The falling ROE = Signifies a decline in profits or inadequate capital allocation
Sudden ROE jump prior to IPO could be a fake (one-time profits or cost reductions)
ROE patterns tell you whether the business is increasing its profits in a sustainable manner which is vital to long-term investment.
Debt-to-Equity Ratio (D/E Ratio) :
The Debt-to-Equity Ratio is a measure of the amount of debt a business has in comparison against its equity. This ratio can help you determine how financially secure and self-sufficient a business iscrucial when assessing the company prior to going public.
Financial Stability and Leverage
Formula: D/E Ratio = Total Debt / Shareholders’ Equity
A high ratio of D/E means the business is heavily reliant on borrowed funds for growth which is dangerous if interest rates increase or cash flow declines. A lower D/E in contrast suggests more financial stability and less strain for future profits.
Ideal Range Based on Industry:
Sectors that are capital-intensive (like real infrastructure, real estate) D/E as high as 2.25 (or 2.5 is acceptable.
Tech or service-based companies should be ideally having a D/E less than 1.
Zero or very low D/E A great signIt indicates that the company is growing by its capital and cash flows.
What is ideal will depend on the sector — therefore, always check your IPO company’s D/E to industry averages.
Why a High D/E in an IPO Can Be Risky ?
If a business that is about to launch via the IPO already has already a excessive D/E rate this may be considered a red alert:
The company could use an IPO to pay back loans that it has already taken This is a sign that you’re investing into an enterprise that’s weighed down by loans.
The burden of debt can limit the financial flexibility and can increase the chance of a downturn.
If interest rates rise they can impact the profitability of investors in the future.
Always take the time to read The “Objects of the Issue” section of the DRHP If an important portion of IPO proceeds are going to debt repayment, you have to determine whether the business model is worth the risk.
Current Ratio :
It is the Present Ratio is a measure of liquidity that determines whether an organization can fulfill it’s immediate obligations by using it’s cash reserves for short periods. If you are IPO buyers, this offers an overview of the business’s financial state of health and how it is able to manage day-today operations.
Short-Term Liquidity and Working Capital Health
Current Ratio = Current Assets / Current Liabilities
The ratio 1 or more indicates that the business has sufficient short-term assets (like inventory, cash and receivables) to pay for its short-term obligations. A extremely low ratio indicates liquidity problems and a high ratio could indicate that the business isn’t using its assets in a way that is efficient.
Current Ratio Benchmark
The ideal range between 1.2 between 2 and 1.2
less than 1: Could be a sign of potential liquidity shortage
Greater than three: Could suggest the presence of idle assets or poor capital utilization
For companies that are planning to go public A healthy and stable current ratio is a sign of good control of cash flows that is crucial during the first few days of public operations.
Signs of Operational Inefficiency
A particularly small current ratio could indicate:
- Clients are not receiving their payments on time.
- The accumulation of inventory
- Poor receivables management
- In the meantime the current ratio, a extremely large current ratio could indicate:
- Excess cash sitting idle
- Slow turnover of inventory
- Growth opportunities missed because of the use of capital in a conservative way
The analysis of this ratio can help IPO investors determine if the firm has enough cushion to manage sudden shocks or funding requirements.
Net Profit Margin:
Net Profit Margin is an indicator of bottom line which reveals the percentage of a company’s revenue actually converts into profits after all taxes, expenses and other interest are paid. It’s an exact reflection of a business’s efficiency and cost-control discipline.
Net Profit Margin = (Net Profit / Revenue) x 100
Profitability and Insights on Post-Expenses:
This number shows how effective the business is in turning revenue into real earnings. A greater margin indicates better profitability and a better financial health.
In the case of IPO buyers, the report informs the amount of actual revenue the business is conserving – not just earning revenues and earning money.
How do margins reflect cost control and Pricing Power?
High net margins usually indicate price power efficiency, a smooth operation, and strong demand.
Lower margins may indicate an increase in costs, inadequate cost management, or a heightened price market.
The Return On Assets (ROA):
Return on Assets (ROA) measures how an organization uses the resources of its all assets to earn profit. It is particularly important in heavy asset-based businesses like manufacturing, real estate or.
Formula: ROA = Net Profit / Total Assets
How efficiently the company uses its assets?
The term “high ROA” means that a high ROA signifies that the business is getting more profit out from every rupee it invests in their assets equipment and inventory, land etc.
The presence of a lower ROA can be a sign of an inefficient use of assets or operations.
Certain industries have naturally lower ROA due to their capital requirements, so take it in the context.
It is useful for sectors that are capital intensive.
If you’re considering the possibility of an IPO in manufacturing or energy sectors, or in infrastructure, ROA becomes critical. It will reveal how well management is making physical investments income — and also whether the base of assets is effectively utilized.
Operating Profit Margin (EBIT Margin) :
Operating Profit Margin also known as EBIT Margin (Earnings before Taxes and Interest), reflects the performance of the company’s principal operations and excludes non-operating costs like interest income and one-time gains.
Operating Margin = (EBIT / Revenue) x 100
Core Business Profitability
This figure shows what the profitability of your primary business actually is prior to tax and financing costs. In the event that an IPO company is relying on other revenue sources (like the sale of assets or interest) or asset sales, it may be concealing weaker operations.
Does the company rely on the Non-Operating Profit?
A business with a high EBIT margins however a low Net Margin may be suffering from high tax or debt problems.
A company that has a poor EBIT margins, with a positive net profits may be too dependent on one-time gains – not the ideal investment for long-term investors.
Stability over time = a solid Business Model
Growing or consistent EBIT margins for the last 3years or more indicates the company is a robust and effective business capable of dealing with the effects of inflation, increasing costs as well as market stress.
Ratio of Asset Turnover:
The Asset Turnover Ratio determines how effectively the company makes use of their assets to bring in revenue. It’s a measure of the operational efficiency and how efficient or efficient the business is.
Formula: Asset Turnover = Revenue / Total Assets
Effectiveness of Sales with respect to Assets
A greater turnover ratio signifies that the company is making more money per dollar of assetswhich is a clear indication of the company’s operational excellence.
Compare over Time or against Competitors
The company is increasing sales, without overburdening its assets base.
Declining ratio means under-utilized equipment, inefficient processes or slower demand.
Utilize this ratio to assess the efficiency of growth and to determine whether growth is contributing to real revenue growth.
Interest Coverage Ratio :
The Interest Coverage Ratio determines how well a business can cover its interest costs by utilizing its operating profits.
Formula: Interest Coverage = EBIT / Interest Expense
Capacity to pay the interest on debt
This is an important risk indicator — particularly in the event that the company planning to launch an IPO has substantial debt.
Ratio above 3: Comfortable
1.5 to 3 is acceptable but needs to be monitored
Lower than 1.5: Risky -the company may have a difficult time to pay the interest in hard times
Ratio < 1.5 = Red Flag
A low ratio of interest coverage is a sign of the financial strain or excessive borrowing which is not a good sign for a business that is preparing to enter the public market. Avoid IPOs in which the majority of money are being used to service and pay back debt particularly when profits are already stretched.
Increase in Revenue:
Although it is not a formal number, Revenue Growth Rate is one of the most crucial indicators to evaluate the direction of a business.
Seek out 3 to 5 years of CAGR (Compound Annual Growth Rate) of revenue in the DRHP.
Are you able to scale your growth consistently and easily?
Consistent double-digit growth is ideal.
Avoid businesses with fluctuating or declining revenue growth even if the numbers look decent.
Find out if the your growth is natural (from the sales) or organic (from transactions or acquisitions).
Revenue growth can tell you whether the business is increasing market share, gaining new territories, or is the launch of new products all of which are crucial aspects to IPO success.
Conclusion : Investing in a IPO can appear temptingfor who wouldn’t desire to take advantage of the next big stock before it goes public? However, making a blind leap in because of the hype or the excitement can be a costly error. Financial ratios are where they are in. These powerful tools allow you to discern the clutter and determine the company’s actual financial strength and future growth potential.
Through analyzing important metrics like P/E Ratio, EPS, ROE, and others and gaining a better comprehension of the firm’s performance and effectiveness, levels of debt and the sustainability of growth. If you’re an experienced investor or just beginning out with investing, these ratios provide you with a distinct advantage in helping stay clear of red signals and identify companies that have strong foundations.
Be aware that investing in an IPO is more than just an issue of timing. It’s also about taking a well-informed decision. Make the effort to study these numbers, then compare them to industry benchmarks, then read the company’s DRHP attentively. When you do this you can shift your focus away from speculation to strategy, and this is the essence of smart investing. is everything about.