The IPO rush is back. Rationality may not be

In August, 20 companies raised over ₹21,000 crore, marking the busiest month for initial public offerings (IPOs) in a year. Prominent names such as NSE, Reliance Jio, and Zepto are set to list soon, fueling a continued flow of new listings. The average return on the first day of listing has shifted from a 2% discount in the first quarter to a 7% gain between April and June, and a significant 25% premium in July and August.

Out of the 22 companies that went public in the latest period, 18 achieved positive returns on their debut day. This performance may tempt investors to view IPOs as a lottery ticket, hoping for a premium and selling on listing day. However, it is crucial to stress that listing gains should not replace thorough due diligence.

While positive debuts can create a feedback loop, attracting more investors and encouraging additional listings, this can lead to increasingly aggressive valuations. Eventually, rationality will prevail, and the market will identify which businesses truly warrant a premium and which do not. Investors may find themselves holding onto underperforming stocks.

To separate the promising companies from the poor performers, investors should first assess the business's merits. Does it possess a durable competitive advantage in a growing industry? If the industry's outlook is uncertain, even a market leader will struggle to succeed. Similarly, a small player in a cutthroat industry may face extinction.

Financial performance is another crucial factor. Sustainable revenue growth should result in operating leverage and cash flows. Despite the popularity of new-age businesses in the IPO market, profitability is not guaranteed. Companies with strong operating leverage and growth can still be viable investments if their financials hold up.

Investors must also scrutinize cash flows to ensure reported profits are not merely the result of accounting tricks. Debt and working capital intensity are additional factors that warrant attention. In a hot IPO market, valuation becomes paramount. Even a strong business can be a poor investment if the price leaves little room for error. Comparing IPO valuations to those of listed peers using metrics like price-to-earnings or price-to-sales, while adjusting for growth and margin differences, is essential.

Take, for instance, the Bajaj Housing Finance IPO, which debuted during a market peak in September 2024. Its issue price was already higher than the industry average, leading to a listing at more than 100% premium. Subsequently, reality checks have resulted in a substantial 50% loss for investors.

In cases where relevant peers are absent, as in the case of AI application business Fractal Analytics, sustained growth will serve as the benchmark for fair valuation—a benchmark that may take time to establish. Additionally, investors should consider whether the IPO's purpose is a fresh issue or an offer for sale (OFS). A higher proportion of an OFS indicates existing shareholders are monetizing their holdings, while an OFS dominated by such sales requires more careful evaluation of the business prospects.

Lastly, investors should closely examine the offer document, paying more attention to the fine print than the marketing pitch. Important information such as risk factors, related-party transactions, contingent liabilities, outstanding litigation, customer concentration, dependence on key suppliers, and regulatory risks can paint a very different picture from the headline growth numbers.

In conclusion, investors must ask whether they are purchasing a good business or merely buying into the excitement. In a market rife with multibagger expectations, it is crucial to separate the wheat from the chaff and make informed investment decisions.