IPO: Offer price is not the only deciding factor

IT is said that Initial Public Offerings, popularly known as IPOs, can be a safe stepping stone for the first timers, who are entering the equity market. IPOs are supposed to be cheap and provide good upside potential to investors
if they hang around long enough.

For first time investors or those lacking enough experience, the trickiest part is to assess the fair value of the shares on offer in an IPO. This is important as it determines whether you should subscribe to the offer or instead bet your money on a related company already listed on the stock exchanges. But it is easier said than done. Most often prospective investors either get seduced or intimidated by the offer price.

This should not happen in an ideal world. After all an offer price or market price of a share is nothing but a company’s expected or total market value divided by the number of shares. This means that two companies with similar market value may trade at different prices simply due to difference in the number of shares
available for trading. But most of the new investors fail to determine this link between the market value and the share price.

This was clearly visible in the recent IPOs of the power sector companies. The investors have been baffled by the sheer variance in offer price of IPOs and the market price of their listed peers. For instance Adani Power was offered to the investors at Rs 100 per share. In comparison, Tata Power, which in the same line of business (i.e in thermal power) and of similar size (in terms of capacity), is right now trading in the range of Rs 1,200 per share.

On the other side of the spectrum is NHPC, which is being offered to the investors in the price band of Rs 30-36 per share. In comparison, another public sector power utility NTPC is trading at around Rs 210 per share. To a trained eye, there’s nothing unusual in the variation in the market price of various companies in a sector.

But for a retail investor, market price is the most visible and appealing information about the real worth of a company or business that is taken easily without much pondering.

Most retail investors and especially the first time investors in IPOs associate the offer price with the relative cheapness of the stock. To them, NHPC is so much cheaper than NTPC, while Adani Power IPO is a steal compared to Tata Power. They don’t care about the fact that at its lower price band NHPC is asking for around 30 times its earning per share (EPS) in FY09 while NTPC is available at a P/E multiple of just 20.

This brings us to the crux of the issue. How should retail investors with limited resources and experience assess the fair value of an IPO and compare it to related companies already listed on the bourses?

The starting point is to get hold of the company’s red herring prospectus (RHP), which contains all the relevant financial and operational details of the company . RHP as it’s called is freely available on SEBI’s website or the company’s portal.

The first item to look for in the RHP is the face value of the share. Next thing the investor should look for is the company’s capital structure represented by subscribed paid-up capital divided into certain number of shares. These two variables will help us to calculate the total number of shares that will be available for trade. This is important, as it is one of the key determinants of its offer price.

The other factor is earning per share, i.e., total profit divided by the total number of shares. Just to illustrate consider Adani Power IPO. Post IPO, Adani Power’s paid-up equity capital is around Rs 2,180 crore divided into 218 crore shares with face value of Rs 10 each. Now compare it to Tata Power’s capital structure.

At the end of June ’09 quarter, Tata Power’s paid-up equity capital is around Rs 222 crore represented by 22.2 crore equity shares with face value of Rs 10 each. Simply put, Adani Power has nearly ten times more equity shares than Tata Power. This means that for the same market value, Adani Power’s share price will be one-tenth that of Tata Power’s share price.

For instance at Rs 100 per share, Adani Power’s total market capitalisation will be Rs 21,800 crore (Rs 100 multiplied by 218 crore shares). If Tata Power gets the same market capitalisation, its share price would work out to be Rs 982 (Rs 21,800 crore divided by 22.2 crore shares).

But what determines company’s market valuation or market capitalisation? At the most simplest level, market cap is directly depended on company’s earnings or profitability in the preceding 12 months. Higher the net profit, higher will be its market value. Total net profit divided by the number of shares gives us earning per share. Now consider the case of NHPC and compare it to National Thermal Power Corporation (NTPC).

During the year ended March 2009, NHPC earned a net profit of Rs 1244 crore, which translates into a earning per share of Rs 1.01 per share (Rs 1244/1230). Post IPO NHPC paid-up equity capital will rise to Rs 12,300 crore represented by 1,230 crore shares with face value of Rs 10 each. In comparison, NTPC earned a net profit of Rs 8,201 crore during FY09, which works out to be Rs 9.95 per share.

Now divide NHPC offer price with its EPS and its gives you price to earning multiple, commonly known as P/E multiple. In case of NHPC, it works out to be 30 at the lower price band and 36 at the upper price band. In contrast NTPC is trading
at around 21 times its EPS in FY09. Obviously, latter is cheaper than the former.

If we set aside other complex issues involved in valuations such as quality of management, earnings quality and growth prospects, a company with lower P/E is preferable. And in the end, it is always preferable to invest in a company whose business is up & running, rather than a company, which promises to use the proceeds to set-up a business that will generate profits and cash flows in future. As they say, there is many a slip between the cup and the lip!