Should Investors Participate in IPOs? Here’s What You Need to Know

A recent study by SEBI revealed that investor behavior in IPOs is increasingly speculative. On average, investors sold 54% of their allocated IPO shares within a week, and 73% sold within a year.

This makes it very clear that listing gains are the primary incentive for the majority of IPO subscribers, and as long as the markets are as active as they are now, this behavior is likely to persist. The euphoria over listing gains wouldn’t abate until subscribers began experiencing losses over extended periods of time. That has previously occurred.

According to EY, India saw a record number of companies enter the market through IPOs in the first half of 2024 (around 27% of global IPOs), generating more than 9% of global IPO proceeds in the period. This trend is expected to continue in the second half of 2024 with several large IPOs.

Recently, investors have had a good IPO experience thanks to the booming market, but that was not always the case. Most investors would have had a terrible experience with IPOs (of new-age Internet companies) in 2022-2023. Therefore, it is important to look at the long-term historical data.

Global market data paints a similar or even worse picture. According to Professor Jay R. Studying U.S. IPO trends from 1980 to 2022, Ritter of the University of Florida found that IPO returns on a three-year basis are negative relative to the benchmark. There are many possible reasons for this pattern, but two are quite obvious:

• The founder or PE (private equity) fund, as the seller, is clearly motivated to maximize their return on investment during the sale process. The valuation of firms that were listed in the previous five years is displayed in Table 1 (12-month Trailing P/E).Most of them are trading at a premium compared to the BSE Sensex, which is valued at 24.8 times (12M Trailing P/E). For most of them, valuations were much greater at the time of listing. There isn’t much more potential for price growth in the future given the current valuations.
• Additionally, the majority of initial public offerings (IPOs) take place during the peak of the company’s earnings cycle or during the bull market. A prime illustration of this is the record 108 initial public offerings (IPOs) in 2007 that came after the stellar market returns of 2004 to 2007. A normalized analysis of a company’s profitability and management quality—which can only be evaluated in the post-listing phase—are necessary to provide an accurate image of the business.

IPOs are a fantastic way for businesses to generate capital and support sound business plans. However, investors need to exercise extreme caution. Although there may be some outstanding companies that go through an IPO, historical evidence indicates (Table 1) that there is a significant disadvantage for investors hoping to profit from an IPO. Before determining the fair value to be paid for the company, it is preferable for the investor to wait, assess the management team’s performance, and watch for the recently listed company to demonstrate normalized earnings.