What is an IPO?
Initial Public Offering (IPO) is a process to raise money through a stake sale by existing shareholders by listing a company on a new stock exchange. It’s named IPO as it’s the first time a company is raising money through public forum though a particular stock exchange. The company, when private, usually depends on private funding from investors such as founders, friends, family, angel investors, and venture capitalists. Although private markets provide growth funding to budding companies, the ultimate exit of private investors is public markets.
IPO is one of the funding sources of equity for a business. An Enterprise’s decision to go public is partly driven by the need for funding, and to attain a potential premium value to its assets, business model and future growth.
Markets refer to this potential premium or discount as multiples because share prices of companies often trade in multiples of their underlying assets or profits. But many companies also trade below the perceived value of their assets and profit.
A listing provides private investors with an exit route mostly at a premium, while founders also get paid if they sell a part of their stake. IPO funding is primarily used by the company to fund growth, repay debt, capital investment etc.
IPO is a stock market launch of a company wherein shares are sold to retail investors as well as institutional investors. The process gives an opportunity to investors to assess and maybe take exposure in the potential growth of a business.
Returns and risks come hand in hand, and it becomes imperative for investors to carefully evaluate the opportunity compared to the offering price of the securities. Not all IPOs end-up becoming a large-cap company, therefore it is essential to assess the associated risks.
Please note: a company which is offering its shares to be public is not obliged to repay the capital invested by the public investors.
What is the process of an IPO?
Not every company is fortunate enough to sail through an IPO process. Going Public is a big step for a private company, which means that the company can now have access to a lot of money, giving it a better opportunity to grow and expand. Further, meeting disclosure criteria and share listing credibility can be used to negotiate for better terms in case of borrowed funds. And even after making into stock exchange bourse, there is no guarantee that the company will have a share price growth over the future.
IPO process is complex and requires time, money, and substantial consulting. While investment bankers are inclined to take most of the companies’ public, it solely depends on the perception of public markets of the upcoming listing.
Selecting an Investment bank: As step one, a company which wants its transformation to a public goes to investment bankers, for advice on the transaction and to provide underwriting services.
Investment banks evaluate the prospects of a business and its past performance. They also look carefully at the business model, industry, and products of the company. An IPO prospectus includes a lot of information about the business that is mostly sufficient to evaluate an investment opportunity.
Companies often select banks that have been engaged with the business in the past because these banks know in and out of the company. Other factors that impact the selection of a bank include the reputation of the bank, the ability to deliver quality research, and underwriting capability.
Regulatory filings: Markets regulators regulate public markets across most of the jurisdictions. Since public markets come in the ambit of market regulators, IPOs are also monitored and evaluated by the regulators.
This process also includes completing the underwriting agreement with the investment bank. Underwriter effectively acts as a broker between public market investors and the company. The investment bank or group of investment banks decide their underwriting capacity.
In this stage, the company also provides necessary information and disclosure to the stock exchange and market regulator. It also registers the prospectus prepared by an investment bank. An IPO prospectus is an extensive document about the company’s business model, business fundamentals, management background, as well as legal information related to the IPO.
Once the prospectus is registered, it is accessed by investors who are willing to invest in the upcoming IPO. Therefore, the prospectus of the company provides a base for investment decision-making of investors.
Pricing of the IPO: After the necessary fillings and approvals, the investment banks that are handling the transaction undertake pricing of the company. The offer price of an IPO is based on valuation, market factors, and business performance.
IPOs are priced in two ways. In a fixed price offer, the offer price of the shares is fixed by the investment bank based on the valuation; this process is usually applied when a small company is going public.
In the book-building process, the investors submit their bids to the investment banks promoting the IPO transaction. This process is used for a large enterprise to obtain a maximum issue price for the stock based on the investors’ expectations. Once investment bankers receive bids, they evaluate the bids provided by investors and arrive at an issue price for the company’s share.
Offer period: After the pricing of the IPO is completed, the offer period commences, which is given in the prospectus. During the offer period, the public market investors subscribe to the IPO of the company.
This period usually decides whether the IPO is ready to hit the market or not. A company should achieve a minimum subscription to make debut in the markets. And the underwriting facility provided by investment banks seeks to ensure that minimum subscription is met.
Allotment of shares: Once the offer period is closed, it is revealed whether the IPOs was oversubscribed or undersubscribed. If the issue is undersubscribed, the investors will receive the same number of shares subscribed by them. When shares are oversubscribed, the underwriters have the option to raise the price, offer additional securities or consider both.
Advantages of IPO
Primary objective is to raise money for a business. Whereas other benefits include:
Darvas Box system Every great trader/investor in the history of the markets had a specific method to approach the markets, which eventually led them to create a good fortune, Darvas Box system is one such method. It is a trend following strategy developed by Nicholas Darvas in the 1950s to identify stocks for good upside potential. This is one of the few methods to trade the markets which uses the combination of both the technical analysis and fundamental analysis for a much more refined decision. The fundamentals were used to identify the stocks, and technical analysis was used to time the entry and exits. Who was Nicholas Darvas? Nicholas Darvas was arguably one of the greatest stock traders/investors during 1950s – 1960s, but surprisingly he was a ball dancer by profession and not a professional stock trader. Even while trading and building his fortune, he was on a world tour for his performances in many countries and took up trading as a part-time job. In November 1952 he was invited to a Toronto Nightclub for which he received an unusual proposition of getting paid in shares by the club owners. At that time, all he knew was there is something called stocks which moves up and down in value, that’s it. He accepted the offer and received 6k shares of a Canadian mining company Brilund at 60 cents per share, with the condition that if the stock falls below this price within six months, then the owners would make up the difference. This was the introduction of a professional ball dancer to the stock market. Nicholas Darvas couldn’t perform at the club, so he bought those shares as a gesture. Within two months, Brilund touched $1.9, and his initial investment of $3000 turned to $11400, netting in almost three times of his investment. This triggered a curiosity into the stock markets, and he started to explore trading. Origin of the Darvas Box theory Initially, he was trading on his broker’s recommendation, tips from wealthy businessmen, he even approached some advisory services or any source that he could get his hands on for the tips, but all led him to losses. After losing a lot of money, he decided to develop his own theory, and after a lot of trial and error, his observations and continuous refinements he eventually invented his theory “The Box Theory”. So what exactly is the Box Theory? Fundamentals Analysis As stated earlier, the box theory uses a judicious bend of both the technical and fundamentals. Darvas believed that in order to spot a good stock or even a multibagger, there should be something brewing up in the respective sector as a whole or some major fundamental change in that specific company. Generally, the fundamentals that Darvas used to study were on a broader sector level, and not the company-specific fundamentals. Even for the specific company Darvas used to look from a general perspective like, is the company launching a new product which could be a blockbuster hit. He completely refrained from looking at numbers and financial statements as his initial experiment with ratios and financial statements didn’t yield any good result. To know more on the three financial statements read: Income Statement (P&L) Balance Sheet Cash Flow Statement Technical Analysis Darvas was a big believer in price action and volume of the stock. He believed if some major fundamental changes were to take place in a company, this soon shows up in the stock price and its volume of trading as more people get interested in buying or selling the stock. With his observations here realized by just observing the price action, he can participate in the rally which gets triggered by some major fundamental development without actually knowing about the change. Using the box theory, Darvas used to scan stocks based on rising volume as he needed mass participation in the rally. Also, he only picked up those stocks that were already rising. His theory is all about “buy high, sell higher” instead of the conventional belief of “buy low, sell high”. After the stock satisfies both the parameters of increasing price and volume with major underlying fundamental change, Darvas looks to enter the stock. Good read on momentum trading. How and where to enter? Major part of the box theory is based on entry and exit levels. To enter a stock, Darvas looked for a consolidation phase preceded by a rally. A consolidation phase is the price action wherein the price moves up and down in a tight range, that is, a non-directional move. He would then mark the high and low of the consolidation phase with the horizontal line, essentially making it a box-like structure, hence the name “Box Theory”. The high point is called the ceiling, and low is called the floor. Whenever the stocks break above the ceiling, Darvas would look to buy one tick above the ceiling with one tick below floor as a stop-loss point. Pyramiding Darvas discovered early on, in order to become successful in the market your winning bets should yield much more profit than the loss in the losing bets. This led him to do pyramiding in his winning trade, which is clearly defined in the box theory. Pyramiding means to increase the existing position if the stock is going in the favour, which leads to a much higher profit in the winning trades. According to the box theory, the repetition of the entry criterion is the new signal for adding onto the existing position. In other words, after a position, if the stocks stage the same setup, that is, a consolidation after a rally, then the break above the ceiling of this new box would signal to increase position with the revised stop loss of 1 tick below the new floor. In any case, whenever the stock falls below the current floor, the entire position would we sold off at once. This is the only exit condition in the box theory, and there is no method of booking profit upfront as Darvas believed in holding on to a rising stock. The only way to book profit is to let the stock to take out the revised stop loss.
What is earnest money? Earnest money refers to a sum of money that is paid by the buyer to the seller as a form of reassurance of future payments during the sale of a house. Paying earnest money is also beneficial to the buyer because it gives him leverage to arrange the remaining funds. Earnest money can be deposited via a direct home deposit, an escrow account or in the form of good faith money. How does earnest money work? Earnest money is paid before closing on a house sale. When the seller and buyer come to an agreement on the house sale, the seller must take the house off the market. Earnest money serves the purpose of assuring the seller that the deal would not fall through. The amount paid as earnest money is usually 1-3% of the total sale value of the house. Most sellers prefer to hold earnest money in an escrow account. In case the deal does not materialize, the money can be given back to the buyer directly from the escrow account. This removes the concerns any buyer may have about whether the money would be returned by the seller or not. In case the buyer and seller go ahead with the sale, the earnest money becomes a part of the down payment. Thus, the buyer would only pay the remaining amount of the down payment. However, in case the agreement does not materialize between the buyer and the seller, the earnest money is returned to the buyer after deducting the escrow fees from it. With money locked in on one house, buyers are less likely to close a deal with any other house seller. How is the amount of earnest money decided upon? The percentage of the total amount that can be taken as earnest money varies from state to state as policies are different. Additionally, the market scenario is also a major factor affecting the amount of earnest money to be paid. Under normal conditions, 1-2% of the total sale value can be taken as earnest money. However, if the market does not have a high demand for houses, then the percentage charged as earnest money could be lower around 1%. In markets with high demand, this percentage could be as high as 3%, or even 5%. To outbid other buyers, one can pay a larger sum of money as earnest money. This would increase the buyer’s chances of securing the property. Why is earnest money important? Earnest money may not always be mandated by the seller, but in a highly competitive market earnest money may be necessarily required. Paying the earnest money makes the agreement official. Without earnest money, the deal may not be considered official in many regions. It is one of the four stages of payment while making a deal on a house. However, in certain instances, even after the payment of the earnest money, the deal may not materialize. Typically, a buying agent should be able to assist the buyer in such a case. What conditions must be met for earnest money to be refundable? Earnest money has certain contingencies attached to it for the protection of both the seller and the buyer. Even after the seller has accepted the earnest money deposit, there are certain contingencies that must be met before the deal can be finalized. These include the following: Home inspection contingency: This contingency is placed so that buyers can back out of the agreement in case the there are some faults in the property, and it is in need of repair. However, it is not necessary for the buyer to call off the deal in such a case. He can simply work with the seller to reach a mutual decision rather than scraping away the deal completely. Financing Contingency: It might be the case that a buyer had not been approved for a mortgage before making the earnest deposit. Here the financing contingency would protect the buyer. If the mortgage does not get approved even though the earnest money had been paid, then the financing contingency allows the buyer to walk away from the deal along with the refunded earnest money. Appraisal Contingency: This protects the buyer in case the property has been overvalued. Here the lender can hire a third-party investigator who can examine whether the property has been priced at a fair value or not. If the value of the house comes out to be higher than the fair value, then the buyer can walk away with a refund. Additionally, this contingency can be used to bring down the price of the sale too. Contingency for Selling the Existing home: It is quite possible that contracts are made based on whether the buyer can sell an existing home or not. If the buyer is unable to sell the existing home, then he can walk away with a refund. These contingencies can be waived by the buyer in case he is sure that the deal would close and there would be no backing off. However, it is important to note that contingencies can provide an extra cushion against adverse circumstances and they might come in handy in certain cases. What is the difference between earnest money and good faith deposit? Both terms can be used interchangeably. However, all good faith deposits are not the same as earnest money. A good faith deposit can be made directly to the mortgage lender, while earnest money is usually held in an escrow account. Both serve the purpose if providing a sense of security about the buyer sticking to the same deal and not going elsewhere. The good faith deposit eventually forms a part of the lending process. However, in case the deal does not materialize, it is possible that the borrower would not get his good faith deposit back.
What is market capitalisation? Market capitalisation is one of the ways employed to evaluate the valuation of a company. This aggregate valuation is based on the current market price of the company’s shares and the total number of outstanding stocks. One needs to make the calculation to determine the company valuation. It is primarily outlined by the total market value based on the company’s outstanding shares. This simply means that evaluation by this method can be done only for businesses that are publicly traded. Source: © Djbobus | Megapixl.com Why is it essential for investors? Understanding and calculating market capitalisation of a business are essential, especially for investors, as it guides them make sound investment decisions. A company’s correct value evaluation can help investors choose the right shares to invest in as per their need. However, it is imperative to keep in mind that various internal and external factors can also impact the number, as market capitalisation is based upon the value of the company’s current shares and number of outstanding stocks. The share price of a listed company can move in an upward or downward direction due to multiple factors, such as critical financial announcements made by the company, changes in the management or structure, fluctuations in market conditions, etc. As these factors impact the price of the company’s current shares, the market capitalisation also changes, going up or down with increase or decrease in the numbers. From an investor’s standpoint, evaluating market capitalisation using this method is crucial, especially while charting a long-term investment plan. Additionally, the returns and risks associated while investing in a particular company are also imperative for the investors. Market capitalisation plays an important role in aiding the investors while choosing stocks that meet their criteria while investing in various companies to maintain the portfolio. Meanwhile, it is vital to keep in mind that the market capitalisation demonstrates the stage of a company’s development. Source: © Noamfein | Megapixl.com What are the types of companies based on the market cap? Knowing the formula employed to calculate the market capitalisation can provide clarity to investors. For instance, a particular company has 10 million outstanding shares, and the current market price is $100 per share. In this case, market capitalisation of the company will be 100,00,000 x 100 = 1,000,000,000. The stocks of listed companies fall into three categories based on this popular method of evaluation. Investors usually choose stocks from judging market capitalisation valuation. Usually, investors also decide for balanced investment in different combinations of stocks with different market capitalisation to minimise risk. Stocks of companies with a market capitalisation of $10 million or above fall under the category of large-cap stocks. Companies with a market capitalisation in the range of $2 billion to $10 billion are called mid-cap players or mid-cap stocks. Companies with a market cap of $300 million to $2 billion are called small-cap stocks. Large-cap stocks: Companies with large capitalisation are usually considered stable businesses in the market. Thus, investing in large-cap companies is less risky compared to investing in other stocks. Though these are companies have a significant market cap, the returns they offer are generally on the lower side. It is believed that these companies have reached the highest point of their development by being in the market for many years and providing a stable performance for years. Thus, even with major announcements that could have a significant impact on the share price, investors are unlikely to see any significant change in their share price. Investing in large-cap companies offers minimum risk, and the growth is also less aggressive than emerging companies. Therefore, investment in a large-cap company is considered conservative. Mid-cap stocks: Companies with mid-range market capitalisation are poised for particular growth. These companies are also somehow stable, making them deliver a promise of future growth. Most importantly, they demonstrate that the business is set up in a particular way. Investing in mid-cap companies can be riskier compared to investing in large-cap companies. Though these companies are not fully established like the large-cap companies, these stocks have growth potential. On a positive note, investing in mid-cap companies is less risky than the small-cap ones. Notably, the returns mid-cap companies can offer are usually higher than the large-cap companies, making it attractive for the investors. Small-cap stocks: Investing in companies with small market capitalisation is a precarious step. However, these stocks are lucrative to many investors. Small-cap companies are new in town; they are up-and-coming and not very much established in the industry than the mid-cap and large-cap ones, making them highly risky. However, investors’ risk would be highly paid off if these players find success, as they hold strong potential to grow. Therefore, investing in small-cap stocks can be an aggressive investment option. Source: © Lovelyday12 | Megapixl.com Important aspects of valuation to keep in mind: While evaluating the market capitalisation of a company, investors need to study a few critical areas that could impact investment decisions. Following are the relevant ratios to take into consideration. Price-to-earnings ratio: One of the critical ratios is considered while evaluating any company’s market capitalisation is the price-to-earnings ratio. While buying shares of a particular company, this ratio will help the investors project returns for the future. Detailed discussion at: Price to Earnings Ratio - (P/E Ratio) Price-to-free-cash-flow ratio: This ratio is also utilised to measure the expected returns. Price-to-book value: This ratio is calculated by deducting the total value of liabilities from the total book value of the company's assets. Enterprise-value-to-EBITDA: This ratio helps investors evaluate and measure the operational returns generated in the short term. Free-float market cap: The number of outstanding shares that are kept for investors to trade publicly is called float. This method excludes the shares owned by the company's executives.
Falling Knife A falling knife is a colloquial term which is often used in the financial market. The term is specifically used when the price of the security falls quite rapidly or sometimes also referred to when the price keeps falling for quite some time. The term often comes across as “Don’t try to catch a falling knife” or “trying to catch a falling knife is very risky”. Why is a falling knife so risky? The price moves every second throughout the trading window and keeps doing so every next trading session. Therefore, price is always said to be in motion, it could either be an upward or downward movement. When the price falls with very high velocity like what the world witnessed during the initial phase of Coronavirus pandemic, then this specific movement or price is said to be a falling knife. This downward momentum is so strong that there is virtually no level where the price stabilizes until the fall is not ended. Every support level, major or minor gets hammered, and during the fall, no enthusiasm is seen from the buyers. Therefore, the sellers keep on selling the security even at lower prices, without enough buyers to absorb the entire supply. Hence the downward movement is on till the sellers feel that the market has reached an oversold price level and stop selling further. This is when the fresh enthusiasm of buyers comes in, and prices start to move up. What does it mean to “Catch a falling knife.” During the course of severe correction in the market, it is tough to predict or estimate some support areas where the supply may end, and the price may halt. Trying to catch a falling knife means taking a very high risk and trying to buy the security at current levels in anticipation that the price would reverse from here. In the normal conditions, generally more accurate estimates can be made as to from where the price may reverse but understanding the correct price at which one should buy in the case of a severe downtrend is not so easy. Therefore, if the timing goes wrong while buying the security, then the trader may not even get a chance to get out around the same price. This situation is exactly like trying to catch a falling knife in the real scenario as in, if the knife keeps on falling after the intervention by your hand in an attempt to stop it, then it would probably cut through your hands. What are the reasons for the occurrence of a falling knife? The falling knife is a dangerous downward move which is accompanied by huge volume. That means mass participation generally takes place during these kinds of moves as moving prices with such a very high momentum cannot be a one-man show, especially in a liquid market like ASX200 or Dow Jones. Image Source: ©Kalkine Group 2020 There could be many reasons which may instil a sense of excessive fear amongst the market participants, which ultimately triggers these moves. Here are a few examples of such reasons Earnings Report Every quarter the listed companies declare their earnings report to the public. Every investor of the company has his own expectations with respect to the company’s performance. But not always, the company meets the investor’s expectation and sometimes leads to disappointment. If the company’s performance is totally not acceptable by the investors, then it may also trigger excessive selling of shares which may last for a few weeks. Global Threat The most recent example of a global threat is Coronavirus pandemic. In the initial phase of the pandemic, during Feb and March 2020, the markets across the globe were depicting the exact movement of a falling knife. The fall was so intense that the only mechanism that was stopping the markets from falling further were the lower circuits. Other global threat or emergencies like a terrorist attack, severe natural calamity etc. may also be the reasons for such aggressive downfall. Technical Breakdown Technical breakdown refers to a break of a significant support level on the price chart. Sometimes a major technical breakdown is enough to trigger a ferocious selling. This happens mostly after the break of long-term support or a firm support level. These technical levels often provide a warning well before the breakdown, although may not always be correct, a trader can definitely become cautious after the breach of these levels. How to profit from a falling knife? The ideal trade to place during a falling knife is to go short on the security and follow the trend. Trend following approach may help even better if the trader could enter around the beginning of the move and ride the trend all the way to the bottom. However, there is never the “only way” in the market, and there is another bunch of traders/investors who think the opposite and try to buy during the fall. This is called a mean-reversion approach because it is expected that if the price falls too much too quickly, then it tends to deviate from its mean price. These investors bet on the assumption the price would soon revert back to its mean by giving an opposite move. Bottomline A falling knife is a ferocious down move which is difficult to trade for both the short or long position. Traders need to have quite an accurate timing of their trades. If timing the move is done correctly, then a trader can make money both ways else it isn't easy. For the new traders with less experience, it is generally recommended to sit aside till the calm sets in.