Go Beyond the Brand, Read the Prospectus
It's easy to get excited about a company whose app you use daily. However, a popular product doesn't automatically make it a great investment. The first step in a logical evaluation is to read the Draft Red Herring Prospectus (DRHP). This document, filed
with SEBI, is a legal disclosure of the company's business operations, financial health, promoters, and potential risks. While it can be hundreds of pages long, focusing on a few key sections can provide invaluable insights that no news headline can offer. Pay close attention to the company’s history, the management's background, and any pending legal proceedings against the promoters or the business.
Analyse the 'Objects of the Offer'
One of the most critical sections in the DRHP is the 'Objects of the Offer'. This tells you exactly why the company is raising money. Is it for a 'Fresh Issue' of shares, where the capital will fund business expansion, technological upgrades, or debt repayment? Or is it primarily an 'Offer for Sale' (OFS), where existing shareholders like founders and early investors are selling their stakes? While a mix is common, a large OFS component might suggest that the early backers are cashing out, which warrants caution. Funds used for growth are generally a positive sign, whereas funds used just to provide an exit for others should be scrutinised.
Scrutinise the Financial Health
New-age, tech-focused companies are often loss-making, as they prioritise growth and market capture over short-term profits. So, instead of looking for profits, focus on the 'path to profitability'. Examine revenue growth over the last three to five years. Is it accelerating? Look at metrics like gross margins and contribution margins, which indicate if the core business is profitable per unit or transaction. A company that shows consistent revenue growth and improving margins is more attractive than one with stagnant sales and widening losses. Also, check the balance sheet for debt levels; high and rising debt can be a red flag.
Understand the Non-Financial Metrics
For many digital businesses, traditional financial ratios don't tell the whole story. Investors need to look at Key Performance Indicators (KPIs) relevant to the industry. For an e-commerce or food delivery platform, this could be Gross Merchandise Value (GMV), Average Order Value (AOV), number of transacting users, and customer acquisition cost (CAC). A growing user base and high transaction frequency suggest a strong business model with a network effect. The DRHP will often detail these metrics, giving you a clearer picture of the company's operational performance and market position.
Question the Valuation
Valuation is where hype often trumps fundamentals. New-age companies are frequently priced at high multiples. The DRHP will include a 'Basis for Issue Price' section, which often compares the company to its listed peers. Compare the IPO's Price-to-Earnings (P/E) or Price-to-Sales (P/S) ratio with its competitors. If the IPO is priced at a significant premium to larger, more established players without a clear justification for superior growth, it may be overvalued. History shows that many IPOs struggle after listing if the initial price is too high, so it's wise to be cautious and not get swept up in the fear of missing out.
