Beware before you buy an IPO!

There can be nothing more depressing than applying for an Initial Public Offering with great enthusiasm only to find later that the company was worthless.
And instead of making a hefty profit, you had to settle for an embarrassing loss.
The best way to avoid this is by reading the prospectus for the issue.
What is a prospectus?
Any company making a public issue is required to file its prospectus with the Securities and Exchange Board of India, the market regulator.
A prospectus is the document that contains all the information you need about the company. It will tell you why the company is coming is out with a public issue, its financials and how the issue will be priced.
There are two types of prospectus.
1Draft Offer Document
This is first filed with SEBI.
SEBI may specify changes, if any, to be made. After the changes are made, it is filed with the Registrar of Companies or the Stock Exchange.
The Draft Offer Documentªmust be filed with SEBI at least 21 days before the company files it with the RoC/ Stock Exchange.
During this period, you can check it out on the SEBI web site.

2Red Herring Prospectus
This one does not have details of either the price or the number of shares being offered or the amount the IPO plans to raise.
That's because this kind of prospectus is used in book building issues, where the details of the final price are known only after the bidding is concluded.
All IPOs launch their issues through the book building method.
To understand book building, please read Want to bid for shares?
How to read it
The problem with a prospectus is that it is massive.
The Red Herring Prospectus for the Punjab National Bank issue, for instance, is 280 pages. How on earth will any ordinary investor sift through this mass?
Here are the main sections youªneed to look at and what each will tell you:
iTable of contents
It tells you where to find what in the prospectus.
iiRisk factors
These will tell you, in some detail, all the risks the company and the issue are exposed to.
For instance, this section tells you whether there are any legal cases against the company or its directors.
It will inform you if the company's associate companies are losing money and what could affect the company's business in the future.
For example, the PNB prospectus specifically mentions that the business may suffer ifªthe financial institution, IFCI, merges with PNB without the government agreeing to the concessionsªPNB has demanded.
iiiCapital structure
This section will tell you the current capital structure of the company, how many new shares will be issued, etc.
This is important, as issuing new shares could lower the Earnings Per Share (EPS = net profit/ number of shares) till the expansion starts generating returns.
ivObjective of the issue
Why is the company raising money?
It's good if the company has specific investment plans. If it says it wants money for working capital (assets of the company like cash and securities minus liabilities such as loans), there's no real check on where the money will be used.
This section will tell you all about the company's business and its strategy.
The section on 'Management's discussion and analysis of financial condition and results of operations' will tell youªwhat the company management feels about the state of their business.
Check on competitive pressures in the business andªhow the company has fared in the past.
viRegulations and policies
Flip through this section as it tells you if there are any government restrictions on the business.
In bank issues, for instance, this section will tell you about the restrictions on dividend payment, restrictions on Foreign Institutional Investment holdings of shares and other such information, which could have a bearing on the attractiveness of the issue.
viiIssue structure and issue procedure
These sections will explain the basis of allocation, who can apply, the book building procedure, etc.
viiiBasis for issue price
This section will give you reasons for the pricing of the issue by comparing it with other companies in the same business, and by comparing the ratios.
For instance, it will tell you what the average price-earnings ratio (PE = market price/ EPS) for the industry is.
Later, when the company announces the issue price, you can compare the PE with the industry average.
Remember, it isªnot enough for a company to do well -- it is also necessary to see whether the issue is attractively priced. The recent Jet Airways IPO, for instance, was widely seen by analysts as being highly priced.
Finally, don't forget to check out the financials of the company, including the auditor's comments.
Now you are in a position to take a call on the IPO.
Please note: Just because the prospectus has been filed with SEBI, it doesn't mean SEBI recommends the issue. Ultimately, investing in equity is risky. More so if is a company that few have heard of.ª
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