The initial public offering market in India has witnessed extraordinary activity over the past several years, with dozens of companies across sectors listing on the national exchanges and generating intense retail investor interest. The entire IPO application process has been streamlined through trading apps that allow investors to submit bids and manage applications entirely from their smartphones. The application-supported blocked amount mechanism – through which bid amounts are blocked in the investor’s bank account rather than transferred upfront – combined with the mandatory holding of allotted shares in a demat account has made the process transparent, efficient, and largely fraud-resistant compared to the subscription mechanisms of earlier decades.
How the IPO Process Works for Retail Investors
When companies go public in India, they consult investment bankers to determine the offer price; book-built issues (most common) fix the offer price band, i.e., the floor and the maximum price within which investors can bid.
The retail investor (investors applying for shares of up to two lakh rupees) is allocated a reserved portion of the issue (typically thirty-five per cent of the total issue) to protect them against being priced out by institutional investors.
Investors bid during the subscription window (three working days), using the ASBA mechanism, whereby the bid amount is blocked (frozen) in their bank accounts and is debited only if shares are allotted to them.
If the applicant is not allotted any shares, the amount is unblocked without any interest. Allotted shares are credited to the investor’s demat account and begin to trade on the listing date.
It takes six working days, on average, for shares to be listed once the subscription window closes.
Assessing IPOs by Fundamentals and Not Merely Listing Day Excitement
A large and increasing proportion of retail applications in India are made with the objective not of retaining the shares but of selling them off on the listing day to capture the listing premium. Such ‘listing gain’ investors view IPO allotments as a lottery ticket: the expected listing premium times the probability of allotment.
In oversubscribed IPOs with grey market premiums (suggestive of strong listing gains), this approach has rewarded many investors handsomely, with returns that, over a short time frame, greatly exceeded the returns from investing directly in the stock market.
However, by reducing IPOs to a listing premium calculation, investors ignore a vast body of academic literature that shows that many IPOs severely underperform the market (especially over 1, 3, and 5 years) on a listing-price basis (see The IPO Paradox).
Companies with high market expectations and intense investor demand at the time of their listing often disappoint as post-listing earnings growth fails to justify their lofty valuation multiples. The long-term holder of such an IPO gets punished (in terms of valuation) by buying at a premium multiple on listing day and watching the valuation contract over time, while a seller on the listing day has already exited.
Financial Metrics That Every IPO Investor Should Know
When assessing an IPO, retail investors should cultivate the habit of reading the red herring prospectus (the IPO prospectus filed with SEBI) to understand the background, risk factors, use of proceeds, and financial history of the company.
While a document of hundreds of pages, reading the prospectus is a crucial exercise to uncover vital information not often revealed in the pithy news summaries.
The use of proceeds is an especially vital disclosure since an issue with proceeds that mostly go towards retiring existing debt or paying off early investors (offering for sale) represents no fresh capital for growth and only benefits the promoters.
Conversely, a fresh issue that is meant to fund the expansion of capacities, product line, or geographic footprint represents a more attractive investment since the money raised will directly contribute towards building future earnings and shareholder value.
The Role of Market Conditions in IPO Pricing and Timing
Promoters and their bankers are shrewd students of the market and tend to time the IPO launch to coincide with periods of maximum market exuberance and optimism, thereby capturing a rich valuation for their company.
Bullish markets tend to see a larger number of IPOs in the pipeline (a bull market IPO pipeline), with IPO-stage companies commanding valuation premiums over comparable listed companies due to increased risk appetite.
This is rational behaviour from the promoter’s point of view, but presents an adverse selection problem for the buyer: the best time to list is often the worst time to buy.
Conversely, companies that list during market downfalls or sector-specific corrections tend to be priced at a discount to their intrinsic value, offering buyers more room for appreciation once the market rebounds.
The contrarian IPO investor, who applies fundamental analysis to IPOs and is prepared to take up a listing that may not have the hype of a highly oversubscribed issue (the hallmark of a bull market IPO pipeline), has historically done far better in the long term than the momentum investor chasing the biggest and buzziest deals of a given bull market cycle.
