WITH more companies seeking to raise funds via an Initial Public Offering (IPO) and subsequently listing on the junior market, many investors are seeing this as an opportunity to earn above-average returns on their investments. In an IPO, a company raises funds via the sale of equity to the general public for the first time. All the junior market IPOs to date have been oversubscribed reflecting, in part, the strong demand for these companies. Demand has been driven by the higher expected earnings growth rates of these stocks relative to their main market counterparts.

Robust gains on the junior market since its inception, the low returns on fixed-income instruments and the limited investment options currently available to investors have also helped to buoy demand. Further, a number of these companies and their products were already familiar to the average investor and this has also worked in the favour of these listings.

With IPO investment opportunities expected to become more frequent as more companies realise the benefits of being listed on the junior exchange, it is critical for investors to know what to look for before making the decision to invest.

Strong Track Record of Profitability

When looking at a company’s financial performance, one should be forward thinking. That is, there needs to be an assessment of how well the company will be able to withstand the vagaries in the economic cycle. However, as a starting point it is worthwhile to examine the company’s historical performance. Has profit growth been steady over the years? Are profitability ratios above those of the company’s competitors? These are important questions an investor should ask before making the decision to invest as earnings is a major driver of stock market valuation.

While past performance does not guarantee future performance; a strong track record of profitability gives an indication of how well the company is being managed and can assist in setting expectations for future profitability.

Industry Dynamics and Competitive Position

An assessment should also be made of the industry in which the company operates and the company’s competitive standing in that industry. Is the industry in its growth phase where prospects are strong, or is it in its mature phase where industry growth has slowed? Companies that operate in growth industries are likely to fare better than companies operating in declining ones. Other factors such as government policy with respect to the industry and the level of competition should also be assessed as this will give an indication of sustainability and future profitability. The company’s competitive position in the industry should also be considered. A company that has a dominant position within the industry offers differentiated products or caters to niche markets may also have greater pricing power thereby allowing for higher profit margins when compared to its competitors. It is also important to assess the company’s strategy to compete in its market and how successful those strategies are likely to be given the industry dynamics and the economic climate.

Management Team and Board Composition

Management is responsible for developing and executing the company’s business strategy while the board is responsible for protecting the interest of shareholders.

Investors should look for companies with a strong management team and extensive experience in the relevant fields as these persons add significant value to an organisation. Investors should research management’s track record in previous roles as this is important in forming expectations. As it relates to board composition, investors need to consider efforts to minimise or eliminate conflicts of interest and encourage good corporate governance. For example, separating the roles of CEO and chairman and having an acceptable number of independent directors bode well for a stronger governance structure. This assists in enhancing shareholder value. Empirical evidence has shown that companies with stronger corporate governance structures tend to outperform over the long term.

Intended Use of Capital

A clear business strategy that indicates how management intends to use the funds raised and plans to grow the business is critical. Capital investment, machinery upgrades to improve efficiency, expansion into new markets with strong prospects and an increase in product offerings are all desirable uses of funds because they have the potential to increase the profitability of the company over the medium term. Paying down expensive debt can also help to improve the company’s risk profile and enhance its financial flexibility.

Valuation

Perhaps the most important element to consider in the decision-making process is the valuation of the stock. You will need to determine what the stock is worth, that is, its fair or intrinsic value relative to its IPO price. Different methods may be used to determine the intrinsic value of a stock. An intrinsic valuation method derives a price based on the fundamentals of the company, while a relative valuation method compares the company to metrics of other companies within the industry to obtain a value. An example of an intrinsic valuation is a Discounted Cash Flow Method where the company’s projected cash flows (whether dividends or free cash flows) are discounted at the appropriate risk adjusted rate in order to arrive at a fair value. Relative valuation methods on the other hand are based on the principle that similar stocks should trade at similar multiples.

Common multiples that investors look at are Price to Earnings ratio (P/E) or Price to Book Value ratio (P/B). This is compared to the industry or the overall market average to determine if the stock is under or overvalued. Usually, a stock is deemed undervalued if it is trading at lower multiples relative to other stocks within its industry. However, there are some instances where companies with higher growth potential due to a competitive advantage, patented products or first mover advantage relative to other companies, could see their stocks trading at higher multiples. This is sometimes the case with the junior market listings.

The most important aspect of valuation is to invest in companies that are being offered below their fair market or intrinsic value. As the stock appreciates towards fair market value, investors will earn the difference between the purchase price and the fair value as capital gain. With the performance of recent junior market issues, investors may gravitate towards a dearth of attractive investment options.

However, it is critical that investors should do their due diligence to determine whether they are appropriate investments. One does not have to be an expert in the field; after all, your investment advisor can make recommendations. However, it is prudent to have some knowledge as this will help you to understand the information you are being presented with and assist you in determining whether or not that IPO is a worthwhile investment.

Richard Gordon is a research analyst at NCB Capital Markets Limited.