Over the last week or so a number of people have asked me whether a certain Initial Public Offering (IPO) is a good investment or not. Thing is, people don’t realize this is not a simple yes or no question. It depends on a number of things including your objectives and what you already have in your portfolio. Anyway, rather than tell people whether any specific investment is good or not, because I think you need to be a registered Investment Advisor for that, I’ve decided it’s safer for me professionally and probably physically to provide you with some tools, a framework if you will, to analyse things on your own.
As usual I need to put up a disclaimer. This post does not constitute investment advice in any way, shape or form. It is not intended to make you the Wolf of Wall Street or enable you to buy a top of the line pirogue. You probably won’t be able to retire and spend your days watching Kasam Se or Kuch Kuch Hota Hai but you would be able to take a somewhat informed look at a potential equity investment.
Right, skipping all the boring theory, let’s get straight to the point. An equity investment (stocks) is basically the purchase of an ownership stake in a company. No, you can’t buy one share, walk in the company and start firing people, if only eh. However, depending on the structure of the shares you may or may not have the right to vote on specific issues like board memberships or who audits the company or things like that at the AGM.
An IPO basically is the first time a company is issuing shares to the public and they can do this for many reasons. So this is tip #1. Apart from understanding how the company makes money, you need to understand what the purpose of the IPO is. Take anything management tells you with a large grain of sea salt (better for you than regular salt) because they may tell you it’s for you to broaden your holdings or to share the wealth with citizens but seldom are companies that are trying to make a profit so noble.
There are two ways to make money on an equity investment, price appreciation and dividend (piece of the profits) income. When you add these two together we call that the “Total Return”. Price appreciation is when a stock goes up in price above what you paid for it. Thus the key is making sure you pay less than what it is actually worth “in theory”. That theoretical price is what we finance types call the “Intrinsic Value” and yes there are techniques for calculating that but it’s quite technical and would probably make you want to jam a screwdriver in your ear like a Q Tip, the wax cleaner not the rapper.
A quick way at estimating intrinsic value is to look at certain ratios we call “valuation metrics” and compare them either to the company’s long-term averages or to other similar companies. There are a whole host of ratios but there are two that are the most popular, you know, they played Intercol, skipped school to go Green Corner to play arcade games, the ones that wore Travel Fox and Cross Colors jeans. The first is the P/E ratio, this is the big daddy of the ratios. It’s the ratio of the price of the stock over the earnings (profits) per share. Basically it measures how much you are paying to get $1 of income. The smaller the P/E ratio the better. However, beware, some companies have low P/E ratios for a reason, they might be runny tooze. So you need to compare a company’s P/E ratio to its peers or even to its own P/E ratio over time.
The next big, mampee down, oompa loompa valuation ratio is the price to book ratio or P/B ratio. This measures the price of a stock over the book value per share of the company. Book value is the value of its assets minus the value of its liabilities. Investors view a low P/B ratio as a sign that the stock is POTENTIALLY undervalued. So if an IPO is priced below book value that could be a good thing.
So that’s some tools to look at valuation. Now let’s look at dividend income and how to semi-intelligently analyse that. What you want to look at is something we call the “Dividend Yield”. It’s a fancy name but really all you’re doing is taking the total amount of dividends paid and dividing it by the total amount of shares outstanding (including the IPO shares) and that gives you the dividends per share. Then you just divide the dividends per share by the price of the shares and you get the dividend yield. What this gives you is how much return, similar to interest, you’re earning on your investment in the shares. The key here is to take this dividend yield and compare it to the rates of return to other equity investments and even investments in other assets classes like bonds, mutual funds, real estate etc.
So there you have it, now your investment tool belt has maybe a flathead screwdriver, a hammer and a pliers. To be really good you’re gonna need a lot more, you’ll need the handyman’s best friend…duct tape because as Red Green used to say “If the women don’t find you handsome they should at least find you handy”. You’ll probably have to pay investment professionals for that though.