Be it the line-up of financial services, mouth-watering food companies, or the fashion labels’ ramp walk, or the debut of the financial behemoth LIC – the D-Street is witnessing all.

 

Zomato’s much-awaited Rs 9,375 crore initial public offering (IPO) is lined up this week. Soon after, Paytm is planning to raise INR 21,800 Cr ($3 Bn) in an initial public offering (IPO).

 

There is exuberance among investors looking to invest in desi unicorn startups to hit Dalal Street. Everyone wants to be a part of the new economy stocks growth story, which have an outsized impact in other countries.

 

For example, technology commands the richest valuations in the US and Chinese stock markets. However, these profitable companies are also decades-old (Amazon, Facebook, Alibaba, Tencent, et al.)

 

But the picture will be incomplete if we miss noticing the likes of the UBER debacle. In India, IPOs of Reliance Power, DLF, Gammon Infra have all destroyed investors’ wealth in the past. Nevertheless, during this gloom and doom story, IPO of companies with solid business fundamentals have fared well in the markets.

 

 

The present IPO avalanche has been triggered by a strong bull run in the Indian stock market. Increased liquidity, owing to money being pumped in by the central bank and the government, rising capital flows, and previous IPO success stories have contributed to this optimism.

 

In a bull market, people want to latch on to a good brand and have an exciting story. This, coupled with relaxed SEBI norms, has led to an IPO Boom, which is hard to ignore. Moreover, one can see an incredible increase in the number and size of issues globally.

 

 

As this euphoria peaks, investors pay little attention to valuations amid a media frenzy, turning this IPO boom into IPO mania. Familiarity bias and herd mentality overcome the rationality while investing in IPOs. Retail investors hear, see these names day in and day out in the ordinary course of a day. Familiarity bias quickly leads to consumers becoming shareholders too. But it’s essential to remember that not all companies are investment-worthy.

 

These days one is flooded with IPO news – newspapers, experts at news channels, emails, social media – essentially everywhere. It becomes increasingly difficult to resist participating in them. Fear of missing out (FOMO) and herd mentality catch up with the investor.

 

In a bull market, an increased number of IPOs leaves investors with hardly any time or resources to analyze offers. Not only this, the information access to the retail investor is limited.

 

A good company comes out with an IPO. It gets hugely oversubscribed, and allotment is not guaranteed for all retail investors (such a waste of time and effort). The word of caution for the investors is to not be lured with the mirage of listing gains.

 

 

One should never forget that IPOs are never meant to be cheap. A team of well-qualified people out there is paid to sell the IPO to the investors at the highest possible price, thus making the odds of you losing your money much more elevated. Data highlights that the odds of winning to losing in IPOs are 40:60 for the last decade. As a result, value investors like Warren Buffet generally dismiss IPO as a gamble. 

 

Always invest for the long-term prospects, looking at the fundamentals. And if the company is good, good opportunities will always exist post listing too. Either buy it in the secondary market post listing or invest in mutual fund schemes to benefit . Don’t rush into an IPO.

 

Be mindful that whenever one invests in a new company, be it through a pre IPO, an IPO, or post-IPO, what determines returns is the Quality of Business, Growth prospects and Valuations.

 

Zomato, in its DRHP, said it expects costs to increase over time. “Our losses will continue, given significant investments expected towards growing our business.” As a result, Zomato will have to be valued differently. Zomato and other startups (barring NYKAA) planning to list in the coming months are still in the phase where the companies are burning money. Up till now, these companies have been valued based on the future projections and hope to become profitable soon. But it may have to happen quickly to justify the stock market valuation.

 

Investors might also change the lens while valuing such stocks. For example, Dalal Street has always approached stocks based on net profit, EBITDA, discounted cash flows, etc. However, absolute valuation metrics do not hold ground for loss-making new-age tech firms. Moreover, relative valuation is also challenging as hardly any tech companies are listed on Indian bourses to compare.

 

One of the most famous cases to be quoted in the startup space is AMAZON. It is the most competent example that shows that losses might lead to revenues. HBR mentions that Amazon trained its investors how to behave and taught Wall Street. Amazon was listed in its early stages; as a result, investors showed patience for more than two decades for Amazon to be profitable.

 

Because the Indian unicorns have existed for a reasonably long time, investors probably would not be willing to ignore the profitability for too long. The emergent need to evolve new parameters for valuing the new-age tech firms appropriately in the evolving scenario cannot be overlooked. 

 

So, how does one values a loss-making firm? The answer to this question can be found in the way private equity/ venture capitalists perform valuations. Several methods exist like – Berkus method, venture capital method and scorecard method.

 

 

Simply put, invest when you believe that in the long run these tech firms will graduate to a profitable, sustainable enterprise to survive and deliver returns to investors.

 

For assessing this, look at customer lifetime value (LTV), customer acquisition costs (CAC), the payback period on CAC (The money you spend at this stage will be made back over the lifecycle of each customer), average revenue per user (ARPU), repeat user rate, etc. makes more sense.

 

Unit economics is the new mantra – where the focus is on profitability on a per-unit basis. The point to note is that the new economy stocks are valued at multiple of revenues, not profits. Keep in mind the stage in which the startup company is for defining growth milestones. Look at the market potential (TAM/SAM/SOM, trends, drivers), competitive advantage (IP, partnerships, clients, competitors). Value of founding team, promoters is crucial –  proven experience and commitment would impact its trajectory to success.

 

 

So, my dear investors, whatever be the strategy, certain factors are imperative. Fundamentals are essential, whichever lens is used to value. Read the DHRP (though tedious), analyze the fundamentals (using any method you like), and be rational while investing (beware of familiarity bias and herd mentality). Identify IPOs to create wealth, not to destroy.

 

Best Regards

 
Dr. Tarunika Jain Agarwal Ph.D.

 

Alpha Research