Ipo

Table of contents

Serial No.

Particulars

Page No.

1.

IPO – An Introduction

7

2.

Significance of IPO

9

3.

Analyzing an IPO investment

14

4.

IPO Investment Strategies

16

5.

Pricing of an IPO

18

6.

Principal steps in an IPO

20

7.

Book-building Process

24

8.

Case study: Hughes Software Solutions

31

9.

Case study: HDIL IPO Valuation

34

10.

Past IPO Performance

50

11.

IPO Glossary

52

12.

Bibliography

56

1

INITIAL PUBLIC OFFERING (IPO)

The first public offering of equity shares or convertible securities by a company, which is followed by the listing of a company’s shares on a stock exchange, is known as an ‘Initial Public Offering’. In other words, it refers to the first sale of a company’s common shares to investors on a public stock exchange, with an intention to raise new capital. The most important objective of an IPO is to raise capital for the company. It helps a company to tap a wide range of investors who would provide large volumes of capital to the company for future growth and development. A company going for an IPO stands to make a lot of money from the sale of its shares which it tries to anticipate how to use for further expansion and development. The company is not required to repay the capital and the new shareholders get a right to future profits distributed by the company.

Companies fall into two broad categories: Private and Public. A privately held company has fewer shareholders and its owners don't have to disclose much information about the company. When a privately held corporation needs additional capital, it can borrow cash or sell stock to raise needed funds. Often "going public" is the best choice for a growing business. Compared to the costs of borrowing large sums of money for ten years or more, the costs of an initial public offering are small. The capital raised never has to be repaid. When a company sells its stock publicly, there is also the possibility for appreciation of the share price due to market factors not directly related to the company. Anybody can go out and incorporate a company: just put in some money, file the right legal documents and follow the reporting rules of jurisdiction such as Indian Companies Act 1956. It usually isn't possible to buy shares in a private company. One can approach the owners about investing, but they're not obligated to sell you anything. Public companies, on the other hand, have sold at least a portion 2

of themselves to the public and trade on a stock exchange. This is why doing an IPO is also referred to as "going public."

Why go public?? Before deciding whether one should complete an IPO, it is important to consider the positive and negative effects that going public may have on their mind. Typically, companies go public to raise and to provide liquidity for their shareholders. But there can be other benefits. Going public raises cash and usually a lot of it. Being publicly traded also opens many financial doors:  Because of the increased scrutiny, public companies can usually get better rates when they issue debt.

 As long as there is market demand, a public company can always issue more stock. Thus, mergers and acquisitions are easier to do because stock can be issued as part of the deal.

 Trading in the open markets means liquidity. This makes it possible to implement things like employee stock ownership plans, which help to attract top talent.

 Going public can also boost a company’s reputation which in turn, can help the company to expand in the marketplace.

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SIGNIFICANCE OF IPO

Investing in IPO has its own set of advantages and disadvantages. Where on one hand, high element of risk is involved, if successful, it can even result in a higher rate of return. The rule is: Higher the risk, higher the returns. The company issues an IPO with its own set of management objectives and the investor looks for investment keeping in mind his own objectives. Both have a lot of risk involved. But then investment also comes with an advantage for both the company and the investors. The significance of investing in IPO can be studied from 2 viewpoints – for the company and for the investors. This is discussed in detail as follows:

SIGNIFICANCE TO THE COMPANY:

When a privately held corporation needs additional capital, it can borrow cash or sell stock to raise needed funds. Or else, it may decide to “go public”. "Going Public" is the best choice for a growing business for the following reasons:

 The costs of an initial public offering are small as compared to the costs of borrowing large sums of money for ten years or more,

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 The capital raised never has to be repaid.

 When a company sells its stock publicly, there is also the possibility for appreciation of the share price due to market factors not directly related to the company.

 It allows a company to tap a wide pool of investors to provide it with large volumes of capital for future growth.

SIGNIFICANCE TO THE SHAREHOLDERS: The investors often see IPO as an easy way to make money. One of the most attractive features of an IPO is that the shares offered are usually priced very low and the company’s stock prices can increase significantly during the day the shares are offered.

This is seen as a good

opportunity by ‘speculative investors’ looking to notch out some short-term profit.

The

‘speculative investors’ are interested only in the short-term potential rather than long-term gains.

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THE RISK FACTOR

Investing in IPO is often seen as an easy way of investing, but it is highly risky and many investment advisers advise against it unless you are particularly experienced and knowledgeable. The risk factor can be attributed to the following reasons:

 UNPREDICTABLE: The Unpredictable nature of the IPO’s is one of the major reasons that investors advise against investing in IPO’s. Shares are initially offered at a low price, but they see significant changes in their prices during the day. It might rise significantly during the day, but then it may fall steeply the next day.

 NO PAST TRACK RECORD OF THE COMPANY: No past track record of the company adds further to the dilemma of the shareholders as to whether to invest in the IPO or not. With no past track record, it becomes a difficult

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choice for the investors to decide whether to invest in a particular IPO or not, as there is basis to decide whether the investment will be profitable or not.

 POTENTIAL OF STOCK MARKET: Returns from investing in IPO are not guaranteed. The Stock Market is highly volatile. Stock Market fluctuations widely affect not only the individuals and household, but the economy as a whole. The volatility of the stock market makes it difficult to predict how the shares will perform over a period of time as the profit and risk potential of the IPO depends upon the state of the stock market at that particular time.

RISK ASSESSMENT: The possibility of buying stock in a promising start-up company and finding the next success story has intrigued many investors. But before taking the big step, it is essential to understand some of the challenges, basic risks and potential rewards associated with investing in an IPO. This has made Risk Assessment an important part of Investment Analysis. Higher the desired returns, higher would be the risk involved. Therefore, a thorough analysis of risk associated with the investment should be done before any consideration. For investing in an IPO, it is essential not only to know about the working of an IPO, but we also need to know about the company in which we are planning to invest. Hence, it is imperative to know:  The fundamentals of the business  The policies and the objectives of the business  Their products and services 7

 Their competitors  Their share in the current market  The scope of their issue being successful It would be highly risky to invest without having this basic knowledge about the company.

There are 3 kinds of risks involved in investing in IPO:

 BUSINESS RISK:

It is important to note whether the company has sound business and management policies, which are consistent with the standard norms. Researching business risk involves examining the business model of the company.

 FINANCIAL RISK: Is this company solvent with sufficient capital to suffer short-term business setbacks? The liquidity position of the company also needs to be considered. Researching financial risk involves examining the corporation's financial statements, capital structure, and other financial data.

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 MARKET RISK: It would beneficial to check out the demand for the IPO in the market, i.e., the appeal of the IPO to other investors in the market. Hence, researching market risk involves examining the appeal of the corporation to current and future market conditions.

ANALYSING AN IPO INVESTMENT

POTENTIAL INVESTORS AND THEIR OBJECTIVES: Initial Public Offering is a cheap way of raising capital, but all the same it is not considered as the best way of investing for the investor. Before investing, the investor must do a proper analysis of the risks to be taken and the returns expected. He must be clear about the benefits he hope to derive from the investment. The investor must be clear about the objective he has for investing, whether it is long-term capital growth or short-term capital gains. The potential investors and their objectives could be categorized as:

 INCOME INVESTOR:

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An ‘income investor’ is the one who is looking for steadily rising profits that will be distributed to shareholders regularly.

For this, he needs to examine the company's

potential for profits and its dividend policy.

 GROWTH INVESTOR: A ‘growth investor’ is the one who is looking for potential steady increase in profits that are reinvested for further expansion. For this he needs to evaluate the company's growth plan, earnings and potential for retained earnings.

 SPECULATOR: A ‘speculator’ looks for short-term capital gains. For this he needs to look for potential of an early market breakthrough or discovery that will send the price up quickly with little care about a rapid decline.

INVESTOR RESEARCH: It is imperative to properly analyze the IPO the investor is planning to invest into. He needs to do a thorough research at his end and try to figure out if the objective of the company match his own personal objectives or not. The unpredictable nature of IPO’s and volatility of the stock market adds greatly to the risk factor. So, it is advisable that the investor does his homework, before investing. The investor should know about the following:  BUSINESS OPERATIONS:

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What are the objectives of the business?

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What are its management policies? 10

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What is the scope for growth?

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What is the turnover of the labour force?

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Would the company have long-term stability?

 FINANCIAL OPERATIONS:

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What is the company’s credit history?

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What is the company’s liquidity position?

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Are there any defaults on debts?

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Company’s expenditure in comparison to competitors.

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Company’s ability to pay-off its debts.

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What are the projected earnings of the company

 MARKETING OPERATIONS:

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Who are the potential investors?

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What is the scope for success of the IPO?

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What is the appeal of the IPO for the other investors?

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What are the products and services offered by the company?

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Who are the strongest competitors of the company?

IPO INVESTMENT STRATEGIES 11

Investing in IPOs is much different than investing in seasoned stocks. This is because there is limited information and research on IPOs, prior to the offering. And immediately following the offering, research opinions emanating from the underwriters are invariably positive. There are some of the strategies that can be considered before investing in the IPO:

 UNDERSTAND THE WORKING OF IPO: The first and foremost step is to understand the working of an IPO and the basics of an investment process. Other investment options could also be considered depending upon the objective of the investor.

 GATHER KNOWLEDGE: It would be beneficial to gather as much knowledge as possible about the IPO market, the company offering it, the demand for it and any offer being planned by a competitor.

 INVESTIGATE BEFORE INVESTING:

The prospectus of the company can serve as a good option for finding all the details of the company. It gives out the objectives and principles of the management and will also cover the risks.

 KNOW YOUR BROKER: This is a crucial step as the broker would be the one who would majorly handle your money. IPO allocations are controlled by underwriters. The first step to getting IPO allocations is getting a broker who underwrites a lot of deals. 12

 MEASURE THE RISK INVOLVED: IPO investments have a high degree of risk involved. It is therefore, essential to measure the risks and take the decision accordingly.

 INVEST AT YOUR OWN RISK: Finally, after the homework is done, and the big step needs to be taken. All that can be suggested is to ‘invest at your own risk’. Do not take a risk greater than your capacity.

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PRICING OF AN IPO

The pricing of an IPO is a very critical aspect and has a direct impact on the success or failure of the IPO issue. There are many factors that need to be considered while pricing an IPO and an attempt should be made to reach an IPO price that is low enough to generate interest in the market and at the same time, it should be high enough to raise sufficient capital for the company. The process for determining an optimal price for the IPO involves the underwriters arranging share purchase commitments from leading institutional investors. PROCESS: Once the final prospectus is printed and distributed to investors, company management meets with their investment bank to choose the final offering price and size. The investment bank tries to fix an appropriate price for the IPO depending upon the demand expected and the capital requirements of the company. The pricing of an IPO is a delicate balancing act as the investment firms try to strike a balance between the company and the investors. The lead underwriter has the responsibility to ensure smooth trading of the company’s stock. The underwriter is legally allowed to support the price of a newly issued stock by either buying them in the market or by selling them short. IPO PRICING DIFFERENCES: It is generally noted, that there is a large difference between the price at the time of issue of an Initial Public Offering (IPO) and the price when they start trading in the secondary market. These pricing disparities occur mostly when an IPO is considered “hot”, or in other words, when it appeals to a large number of investors. An IPO is “hot” when the demand for it far exceeds the supply. This imbalance between demand and supply causes a dramatic rise in the price of each share in the first day itself, during the early hours of trading. 14

UNDERPRICING AND OVERPRICING OF IPO’s

UNDERPRICING: The pricing of an IPO at less than its market value is referred to as ‘Underpricing’. In other words, it is the difference between the offer price and the price of the first trade. Historically, IPO’s have always been ‘underpriced’. Underpriced IPO helps to generate additional interest in the stock when it first becomes publicly traded. This might result in significant gains for investors who have been allocated shares at the offering price. However, underpricing also results in loss of significant amount of capital that could have been raised had the shares been offered at the higher price.

OVERPRICING: The pricing of an IPO at more than its market value is referred to as ‘Overpricing’. Even “overpricing” of shares is not as healthy option. If the stock is offered at a higher price than what the market is willing to pay, then it is likely to become difficult for the underwriters to fulfill their commitment to sell shares. Furthermore, even if the underwriters are successful in selling all the issued shares and the stock falls in value on the first day itself of trading, then it is likely to lose its marketability and hence, even more of its value.

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PRINCIPAL STEPS IN AN IPO

 Approval of BOD: Approval of BOD is required for raising capital from the public.

 Appointment of lead managers: the lead manager is the merchant banker who orchestrates the

issue in consultation of the company.

 Appointment of other intermediaries:

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Co-managers and advisors

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Underwriters

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Bankers

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Brokers and principal brokers

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Registrars

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Filing the prospectus with SEBI: The prospectus or the offer document communicates information about the company and the proposed security issue to the investing public. All the companies seeking to make a public issue have to file their offer document with SEBI. If SEBI or public does not communicate its observations within 21 days from the filing of the offer document, the company can proceed with its public issue.

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Filing of the prospectus with the registrar of the companies: once the prospectus have been approved by the concerned stock exchanges and the consent obtained from the bankers, auditors, registrar, underwriters and others, the prospectus signed by the directors, must be filed with the registrar of companies, with the required documents as per the companies act 1956. 16

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Printing and dispatch of prospectus: After the prospectus is filed with the registrar of companies, the company should print the prospectus. The quantity in which prospectus is printed should be sufficient to meet requirements. They should be send to the stock exchanges and brokers so they receive them atleast 21 days before the first announcement is made in the news papers.

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Filing of initial listing application: Within 10 days of filing the prospectus, the initial listing application must be made to the concerned stock exchanges with the listing fees.

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Promotion of the issue: The promotional campaign typically commences with the filing of the prospectus with the registrar of the companies and ends with the release of the statutory announcement of the issue.

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Statutory announcement: The issue must be made after seeking approval of the stock exchange. This must be published atleast 10 days before the opening of the subscription list.

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Collections of applications: The Statutory announcement specifies when the subscription would open, when it would close, and the banks where the applications can be made. During the period the subscription is kept open, the bankers will collect the applications on behalf of the company.

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Processing of applications: Scrutinizing of the applications is done.

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Establishing the liability of the underwriters : If the issue is undersubscribed, the liability of the underwriters has to be established.

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Allotment of shares: Proportionate system of allotment is to be followed. 17

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Listing of the issue: The detail listing application should be submitted to the concerned stock exchange along with the listing agreement and the listing fee. The allotment formalities should be completed within 30 days.

Book building is the process of price discovery (Basic concept)

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The company does not come out with a fixed price for its shares; instead, it indicates a price band that mentions the lowest (referred to as the floor) and the highest (the cap) prices at which a share can be sold.

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Bids are then invited for the shares. Each investor states how many shares s/he wants and what s/he is willing to pay for those shares (depending on the price band). The actual price is then discovered based on these bids. As we continue with the series, we will explain the process in detail.

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According to the book building process, three classes of investors can bid for the shares: 1. Qualified Institutional Buyers: Mutual funds and Foreign Institutional Investors. 2. Retail investors: Anyone who bids for shares under Rs 50,000 is a retail investor. 3. High net worth individuals and employees of the company.

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Allotment is the process whereby those who apply are given (allotted) shares. The bids are first allotted to the different categories and the over-subscription (more shares applied for than shares available) in each category is determined. Retail investors and high net worth individuals get allotments on a proportional basis. 18

Example 1: Assuming you are a retail investor and have applied for 200 shares in the issue, and the issue is over-subscribed five times in the retail category, you qualify to get 40 shares (200 shares/5). Sometimes, the over-subscription is huge or the issue is priced so high that you can't really bid for too many shares before the Rs 50,000 limit is reached. In such cases, allotments are made on the basis of a lottery.

Example 2: Say, a retail investor has applied for five shares in an issue, and the retail category has been over-subscribed 10 times. The investor is entitled to half a share. Since that isn't possible, it may then be decided that every 1 in 2 retail investors will get allotment. The investors are then selected by lottery and the issue allotted on a proportional basis. That is why there is no way you can be sure of getting an allotment.

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BOOK BUILDING PROCESS

Book Building is basically a capital issuance process used in Initial Public Offer (IPO) which aids price and demand discovery. It is a process used for marketing a public offer of equity shares of a company. It is a mechanism where, during the period for which the book for the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The process aims at tapping both wholesale and retail investors. The offer/issue price is then determined after the bid closing date based on certain evaluation criteria.

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The Process:  The Issuer who is planning an IPO nominates a lead merchant banker as a 'book runner'.

 The Issuer specifies the number of securities to be issued and the price band for orders.

 The Issuer also appoints syndicate members with whom orders can be placed by the investors.

 Investors place their order with a syndicate member who inputs the orders into the 'electronic book'. This process is called 'bidding' and is similar to open auction.

 A Book should remain open for a minimum of 5 days.

 Bids cannot be entered less than the floor price.

 Bids can be revised by the bidder before the issue closes.

 On the close of the book building period the 'book runner evaluates the bids on the basis of the evaluation criteria which may include •

Price Aggression

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Investor quality

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Earliness of bids, etc. 21

 The book runner the company concludes the final price at which it is willing to issue the

stock and allocation of securities.

 Generally, the numbers of shares are fixed; the issue size gets frozen based on the price

per share discovered through the book building process.

 Allocation of securities is made to the successful bidders.  Book Building is a good concept and represents a capital market which is in the process of maturing.

Book-building is all about letting the company know the price at which you are willing to buy the stock and getting an allotment at a price that a majority of the investors are willing to pay. The price discovery is made depending on the demand for the stock. The price that you can suggest is subject to a certain minimum price level, called the floor price. For instance, the floor price fixed for the Maruti's initial public offering was Rs 115, which means that the price you are willing to pay should be at or above Rs 115. In some cases, as in Biocon, the price band (minimum and maximum price) at which you can apply is specified. A price band of Rs 270 to Rs 315 means that you can apply at a floor price of Rs 270 and a ceiling of Rs 315. If you are not still very comfortable fixing a price, do not worry. You, as a retail investor, have the option of applying at the cut-off price. That is, you can just agree to pick up the shares at the final price fixed. This way, you do not run the risk of not getting an allotment because you have bid at a lower price. If you bid at the cut-off price and the price is revised upwards, then the managers to the offer may reduce the number of shares allotted to keep it within the payment

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already made. You can get the application forms from the nearest offices of the lead managers to the offer or from the corporate or the registered office of the company.

How is the price fixed? All the applications received till the last date are analysed and a final offer price, known as the cut-off price is arrived at. The final price is the equilibrium price or the highest price at which all the shares on offer can be sold smoothly. If your price is less than the final price, you will not get allotment. If your price is higher than the final price, the amount in excess of the final price is refunded if you get allotment. If you do not get allotment, you should get your full refund of your money in 15 days after the final allotment is made. If you do not get your money or allotment in a month's time, you can demand interest at 15 per cent per annum on the money due. How are shares allocated? •

As per regulations, at least 25 per cent of the shares on offer should be set aside for retail investors. Fifty per cent of the offer is for qualified institutional investors. Qualified Institutional Bidders (QIB) are specified under the regulation and allotment to this class is made at the discretion of the company based on certain criteria.

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QIBs can be mutual funds, foreign institutional investors, banks or insurance companies. If any of these categories is under-subscribed, say, the retail portion is not adequately subscribed, then that portion can be allocated among the other two categories at the discretion of the management. For instance, in an offer for two lakh shares, around 50,000 shares (or generally 25 per cent of the offer) are reserved for retail investors. But if the bids from this category are received are only for 40,000 shares, then 10,000 shares can be allocated either to the QIBs or non-institutional investors.

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The allotment of shares is made on a pro-rata basis. Consider this illustration: An offer is made for two lakh shares and is oversubscribed by times times, that is, bids are received for 23

six lakh shares. The minimum allotment is 100 shares. 1,500 applicants have applied for 100 shares each; and 200 applicants have bid for 500 shares each. The shares would be allotted in the following manner:

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Shares are segregated into various categories depending on the number of shares applied for. In the above illustration, all investors who applied for 100 shares will fall in category A and those for 500 shares in category B and so on.

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The total number of shares to be allotted in category A will be 50,000 (100*1500*1/3). That is, the number of shares applied for (100)* number of applications received (1500)* oversubscription ratio (1/3). Category B will be allotted 33,300 shares in a similar manner.

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Shares allotted to each applicant in category A should be 33 shares (100*1/3). That is, shares applied by each applicant in the category multiplied by the oversubscription ratio. As, the minimum allotment lot is 100 shares, it is rounded off to the nearest minimum lot. Therefore, 500 applicants will get 100 shares each in category A — total shares allotted to the category (50,000) divided by the minimum lot size (100).

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In category B, each applicant should be allotted 167 shares (500/3). But it is rounded off to 200 shares each. Therefore, 167 applicants out of 200 (33300/200) would get an allotment of 200 shares each in category B.

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The final allotment is made by drawing a lot from each category. If you are lucky you may get allotment in the final draw.

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The shares are listed and trading commences within seven working days of finalisation of the basis of allotment. You can check the daily status of the bids received, the price bid for and the response form various categories in the Web sites of stock exchanges. This will give you an idea of the demand for the stock and a chance to change your mind. After seeing the 24

response, if you feel you have bid at a higher or a lower price, you can always change the bid price and submit a revision form.

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The traditional method of doing IPOs is the fixed price offering. Here, the issuer and the merchant banker agree on an "issue price" - e.g. Rs.100. Then one have the choice of filling in an application form at this price and subscribing to the issue. Extensive research has revealed that the fixed price offering is a poor way of doing IPOs. Fixed price offerings, all over the world, suffer from `IPO underpricing'. In India, on average, the fixed-price seems to be around 50% below the price at first listing; i.e. the issuer obtains 50% lower issue proceeds as compared to what might have been the case. This average masks a steady stream of dubious IPOs who get an issue price which is much higher than the price at first listing. Hence fixed price offerings are weak in two directions: dubious issues get overpriced and good issues get underpriced, with a prevalence of underpricing on average.

What is needed is a way to engage in serious price discovery in setting the price at the IPO. No issuer knows the true price of his shares; no merchant banker knows the true price of the shares; it is only the market that knows this price. In that case, can we just ask the market to pick the price at the IPO?

Imagine a process where an issuer only releases a prospectus, announces the number of shares that are up for sale, with no price indicated. People from all over India would bid to buy shares in prices and quantities that they think fit. This would yield a price. Such a procedure should innately obtain an issue price which is very close to the price at first listing -- the hallmark of a healthy IPO market.

Recently, in India, there had been issue from Hughes Software Solutions which was a milestone in our growth from fixed price offerings to true price discovery IPOs. While the HSS issue has many positive and fascinating features, the design adopted was still riddled with flaws, and we can do much better.

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Documents Required: •

A company coming out with a public issue has to come out with an Offer Document/ Prospectus.

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An offer document is the document that contains all the information you need about the company. It will tell you why the company is coming is out with a public issue, its financials and how the issue will be priced.

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The Draft Offer Document is the offer document in the draft stage. Any company making a public issue is required to file the draft offer document with the Securities and Exchange Board of India, the market regulator.

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If SEBI demands any changes, they have to be made. Once the changes are made, it is filed with the Registrar of Companies or the Stock Exchange. It must be filed with SEBI at least 21 days before the company files it with the RoC/ Stock Exchange. During this period, you can check it out on the SEBI Web site.

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Red Herring Prospectus is just like the above, except that it will have all the information as a draft offer document; it will, however, not have the details of the price or the number of shares being offered or the amount of issue. That is because the Red Herring Prospectus is used in book building issues only, where the details of the final price are known only after bidding is concluded.

Players: •

Co-managers and advisors

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Underwriters

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Lead managers 26

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Bankers

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Brokers and principal brokers

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Registrars

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Stock exchanges.

CASE STUDY: HUGHES SOFTWWARE SOLUTIONS

Recently, in India, there had been issue from Hughes Software Solutions which was a milestone in growth from fixed price offerings to true price discovery IPOs. While the HSS issue has many positive and fascinating features, the design adopted was still riddled with flaws, and we can do much better.

How did the Hughes issue work? The Merchant Bankers selected "syndicate members" who helped in selling the issue.Orders were collected by the merchant bankers or syndicate members (only), and submitted using the computerised IPO system created by NSE. The NSE system only accepted these orders; it did not reveal any information to investors. Investors could place, modify or delete orders in the "book building period" -- however they were doing this in the blind since the system gave them no information. The NSE system revealed information to the merchant bankers. The full database of orders was passed on by NSE to the merchant bankers, who could then use this for discretionary allocation of shares. 27

Numerous flaws in this: From a basic economic perspective, the IPO is a relationship between the issuer (Hughes) and investors. It is hard to justify the requirement that orders only go to merchant bankers or syndicate members; this greatly shrinks the extent to which the IPO harnesses NSE's remarkable distribution machinery. A superior IPO process would involve investors going to any NSE terminal and placing orders. The essence of modern market design is superior information display for superior price discovery. Investors should be able to continuously see how many shares have been bid for; the shape of the demand function; the cutoff price, etc. Using this information they would be able to think more effectively about order revisions, cancellations, fresh order placement, etc. The Hughes IPO, done through the space age VSAT technology of NSE, uses standards of transparency associated with a 19th century market design. In the Hughes IPO, the merchant bankers specified a band, from Rs.480 to Rs.630, in which orders had to fall. The merchant bankers proved to be wrong, and the IPO suffered from severe underpricing. If we take price discovery seriously, we should let the market set the price. The Hughes IPO process was too elongated in time. The IPO process should obtain price discovery in a short time-period where everyone interested in the issue is trading on the screen at the same time. An issue that lasts for more than an hour raises the cost for participants to constantly monitor the order book and revise orders. The sale of part of the issue at a fixed price (discovered at the auction) reduces the size of the auction and raises the probability of market manipulation at the auction. There should be no discretionary allocation of shares; instead shares should be allocated purely by price--time priority.

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Ideal IPO Process: On Monday morning, the newspaper should carry an advertisement which is the prospectus of the IPO, which only talks about the firm and is silent on valuation. The IPO should take place on Tuesday evening, from 4 PM to 5 PM. The auction should be a simple uniform-price auction with full transparency. A picture of the demand schedule, and the cutoff price, should update on the screen in realtime. Investors should be able to go to any NSE terminal and place orders into the auction. This harnesses 10,000 odd computer screens in 300 cities all over India in the auction process. From the issuers perspective, NSCC should perform the credit enhancement exactly as it does on the equity market. At a legal level, all orders on the screen should be placed by NSCC, thus shielding the issuer from the credit risk associated with anonymous order placement. There should be no fragmentation of the shares on offer. All shares to be sold should go through a single auction. If a retail investor wanted to "access the IPO at prices close to the offer price" she would just place non--competitive bids at the IPO, where she bids to buy (say) 100 shares at the IPO price, whatever it proves to be. Allocation of shares in the depository should take place on Tuesday itself. There should be no physical shares. Trading on NSE should start on Wednesday (the next day). This gives us a one-day lag between the IPO and the start of trading. 29

This proposed IPO process sounds startlingly effective. To put it in perspective, it is part of the same disintermediation process that we have seen in other areas of the financial markets. With anonymous, electronic trading on the equity market, the broker/dealer has been fundamentally disintermediated out of secondary market trading, which is now dominated by the actions of buyers and sellers (and not intermediaries). In that same fashion, the IPO process proposed here uses technology to link up the issuer and the investor with a transparent pricing mechanism, and eliminates the traditional overheads of intermediation.

HDIL IPO

VALUATION

30

ABOUT HDIL: HOUSING DEVELOPMENT AND INFRASTRUCTURE LIMITED (HDIL) is a part of the Wadhawan Group (formerly known as the Dheeraj Group), which has been involved in real estate development in the Mumbai Metropolitan Region for almost three decades.

Since 1996, HDIL has been satisfying the diverse needs of scores of home seekers in Mumbai Metropolitan region. Their business focuses on real estate development, including construction and development of residential projects, commercial, retail and slum rehabilitation projects. A sincere study of the market and a strong feeling to meet the needs of the lower and the middle income group prompted HDIL to help these people tide over difficult times and harrowing experiences of buying a home. HDIL had acted pro-actively in identifying the intricate needs of its residents and offered them just what they needed. It provided and still provides all services under one roof through tie-ups with banks and HFC’s. 31

With numerous projects to its credit and lakhs of happy and satisfied home buyers, HDIL has carved a niche for itself in the real estate industry and has made its mark in the hearts of millions of people.

HDIL’s Board of Directors : In tune with its efforts to evolve into a professionally managed Corporate Structure, HDIL has broaden its Board composition by inducting people of high standing from the banking industry, legal and the audit profession as Independent Directors. The Company now has an ideal mix of Executive and Independent Directors, which gives it an advantage of expertise of various fields in effective management and consistent growth.

MISSION: HDIL is committed to creating microstructures, megastructures and infrastructure for the nation and creating value for our customers, investors, employees & society at large. Their mission is to be an icon in Infrastructure & Real Estate Development, defining:  QUALITY

– Conforming to standards

 MARKMANSHIP

– Par Excellence

 CUSTOMER SATISFACTION

– Their Motto to deliver the best at all time

FINANCE: Finance for buying flats in any of the HDIL projects can be obtained through any one of the following Housing Finance Companies:  HDFC 32

 LIC  GIC  Dewan Housing Finance Corporation Limited  VYSYA Bank Housing Finance

Housing Development and Infrastructure Ltd – IPO

HDIL IPO - opened for subscription on 28 June, 2007 and closed on July 03, 2007. About the Company: Since 1978, HDIL has been satisfying the diverse needs of scores of home seekers in Mumbai, the commercial capital of India and Bangalore. It was not just the intention of doing business by being responsible for marketing affordable homes; the very inclination was to give the best to the home seeker fraternity at large.

Issue Details : Issue of Equity Shares# 30,000,000 Equity Shares of which Employee Reservation Portion# 600,000 Equity Shares Net Issue# 29,400,000 Equity Shares Of which: Qualified Institutional Buyers (QIBs) Portion At least 17,640,000 Equity Shares* of which Available for Mutual Funds only 882,000 Equity Shares* Balance of QIB Portion (available for QIBs including Mutual Funds) : 16,758,000 Equity Shares* Non-Institutional Portion 2,940,000 Equity Shares* Retail Portion 8,820,000 Equity Shares* Green Shoe Option Portion1 Up to 4,500,000 Equity Shares The Issue and Green Shoe Option Portion Up to 34,500,000 Equity Shares Pre and post-Issue Equity Shares: Equity Shares outstanding prior to the Issue : 180,000,000 Equity Shares 33

Equity Shares outstanding after the Issue (excluding the exercise of the Green Shoe Option) : 210,000,000 Equity Shares Equity Shares outstanding after the Issue (including the exercise of the Green Shoe Option in full) : 214,500,000 Equity Shares

IPO VALUATION: DCF ANALYSIS

INTRODUCTION: In simple terms, discounted cash flow tries to work out the value of a company today, based on projections of how much money it's going to make in the future. DCF analysis says that a company is worth all of the cash that it could make available to investors in the future. It is described as "discounted" cash flow because cash in the future is worth less than cash today.

For example, let's say someone asked you to choose between receiving Rs100 today and receiving Rs100 in a year. Chances are you would take the money today, knowing that you could invest that Rs100 now and have more than Rs100 in a year's time. If you turn that thinking on its head, you are saying that the amount that you'd have in one year is worth Rs100 today - or the discounted value is Rs100. Make the same calculation for all the cash you expect a company to produce in the future and you have a good measure of the company’s revenue. There are several tried and true approaches to discounted cash flow analysis; we will use the free cash flow to firm approach commonly used by Street analysts to determine the "fair value" of companies.

34

The Forecast Period: The table below shows good guidelines to use when determining a company's excess return period/forecast period:

Company Competitive Position Slow-growing company; operates in highly competitive, low margin industry

Excess Return/Forecast Period 1 year

Solid company; operates with advantage such as strong marketing channels, recognizable brand name, or regulatory

5 years

advantage Outstanding growth company; operates with very high barriers to entry, dominant

10 years

market position or prospects

How far in the future should we forecast? Let's assume that the company is keeping itself busy meeting the demand for its Infrastructure development. Thanks to strong marketing channels and upgraded technology and HDIL has been satisfying the diverse needs of scores of home seekers in Mumbai Metropolitan region. Their business focuses on real estate development, including construction and development of residential projects, commercial, retail and slum rehabilitation projects. There is enough demand for Infrastructure development to maintain five years of strong growth, but after that the market will be saturated as new competitors enter the market. So, from the above table, we will project cash flows for the next five years of business. 35

Growth Rate: HDIL is expected to grow at to have CAGR of 42 %( source: Emkay Research). We take fixed growth rate of 42% for DCF valuation for coming 5 years.

Reinvestment Rate: If we relax the assumption that the only source of equity is retained earnings, the growth in net income can be different from the growth in earnings per share. Intuitively, note that a firm can grow net income significantly by issuing new equity to fund new projects while earnings per share stagnate. To derive the relationship between net income growth and fundamentals, we need a measure of how investment that goes beyond retained earnings. One way to obtain such a measure is to estimate directly how much equity the firm reinvests back into its businesses in the form of net capital expenditures and investments in working capital.

Equity Reinvestment Rate = Growth Rate / ROE = 42/76 = 55.26 %

Forecasting Free Cash Flows: Free cash flow is the cash that flows through a company in the course of a quarter or a year once all cash expenses have been taken out. Free cash flow represents the actual amount of cash that a company has left from its operations that could be used to pursue opportunities that enhance shareholder value - for example, developing new products, paying dividends to investors or doing share buybacks.

36

Free cash flow

= EBIT (1-tax) – [EBIT (1-tax) × Reinvestment Rate]

EBIT (1-tax) nth year = EBIT (1-tax) n-1 year × (1 + growth rate)

Rs in mn Current Year

2008

2009

2010

2011

2012

Expected Growth Rate

-

42%

42%

42%

42%

42%

EBIT (1-tax)

6181

8777

12463

17698

25131

35686

Equity Rate

-

55.26% 55.26% 55.26% 55.26% 55.26%

-

22185

Reinvestment

FCFE

30394

41639

57046

78153

Calculating the Discount Rate A wide variety of methods can be used to determine discount rates, but in most cases, these calculations resemble art more than science. Still, it is better to be generally correct than precisely incorrect, so it is worth your while to use a rigorous method to estimate the discount rate. A good strategy is to apply the concepts of the weighted average cost of capital (WACC). The WACC is essentially a blend of the cost of equity and the after-tax cost of debt.

37

Cost of Equity (Re): Unlike debt, which the company must pay at a set rate of interest, equity does not have a concrete price that the company must pay. But that doesn't mean that there is no cost of equity. Equity shareholders expect to obtain a certain return on their equity investment in a company. From the company's perspective, the equity holders' required rate of return is a cost, because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. Therefore, the cost of equity is basically what it costs the company to maintain a share price that is satisfactory (at least in theory) to investors. The most commonly accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM), where:

Cost of Equity = RF + Beta (Rm-Rf)

Rf - Risk-Free Rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate of government

bonds

is

frequently

used

as

a

proxy

for

the

risk-free

rate.

ß - Beta - This measures how much a company's share price moves against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable.We take Beta of comparable firm i.e Unitech which is having beta of 1.1

(Rm – Rf) Equity Market Risk Premium - The equity market risk premium (EMRP) represents the returns investors expect, over and above the risk-free rate, to compensate them for taking extra risk by investing in the stock market. In other words, it is the difference between the riskfree rate and the market rate.

38

Cost of Debt (Rd): As companies benefit from the tax deductions available on interest paid, the net cost of the debt is actually the interest paid less the tax savings resulting from the tax-deductible interest payment. Therefore, the after-tax cost of debt is Rd (1 - corporate tax rate).

Weighted Average Cost Of Capital (WACC): The WACC is the weighted average of the cost of equity and the cost of debt based on the proportion of debt and equity in the company's capital structure. The proportion of debt is represented by D/V, a ratio comparing the company's debt to the company's total value (equity + debt). The proportion of equity is represented by E/V, a ratio comparing the company's equity to the company's total value (equity + debt). The WACC is represented by the following formula: WACC

= =

Cost of Equity + Cost of Debt E/V x Re + Rd x (1 - corporate tax rate) x D/V.

E/V

0.66

Rf

7.44

Corporate tax

30%

Beta

1.1

D/V

0.34

Rm

13.5

Cost of Debt

Cost of Equity

D/V x (1 - corporate tax rate)

E/V x [Rf + Beta (Rm-Rf)]

0.34 [1-0.30]

0.66 [7.44 + 1.1 x 6]

WACC = Cost of Debt + Cost of Equity = 9.5%

Present Value: The present value of a single or multiple future payments (known as cash flows) is the nominal amounts of money to change hands at some future date, discounted to account for the time value 39

of money, and other factors such as investment risk. A given amount of money is always more valuable sooner than later since this enables one to take advantage of investment opportunities. Present values are therefore smaller than corresponding future values.

When future cash flow of the company is divided by the discount rate we get the present value of that predicted years cash flow.

Present Value n

= Predicted cash flow n / (1+ discount rate)n

Where, n = year Rs in mn

Free Cash Flow Discount rate Present value

2008 3927

1.095 3586

2009 5576

2010 7918

(1.095)

(1.095)

² 4650

³ 6030

2011 11243

2012 15965

(1.095)4 (1.095)5 7820 10141

TERMINAL VALUE

Perpetuity Growth Model: 40

The Perpetuity Growth Model accounts for the value of free cash flows that continues into perpetuity in the future, growing at an assumed constant rate. Here, the projected free cash flow in the first year beyond the projection horizon (N+1) is used. We have assumed perpetuity growth rate for HDIL as 6% Beyond 2012 HDIL is expected to grow at 6% p.a i.e. at its perpetuity rate, hence net income for the year 2013 will be: Net income of 2012 × (1+ perpetuity growth rate) =

35686 × (1+0.06)

=

Rs. 37827 mn

Reinvestment rate after 2012 (Terminal Point): Reinvestment rate = Perpetuity Growth rate / Return on Equity Here, return on equity is rate at which company expect to get returns on its investments after terminal point i.e. 2012. Return on equity will drop to the stable period cost of capital of 9.5%. Reinvestment rate (terminal point)

Free cash flow

=

6/9.5

=

63%

= EBIT (1-tax) – [EBIT (1-tax) x Reinvestment Rate]

Therefore, 41

Free cash flow 2013

=

37827 – [37827 x 52%]

=

Rs. 13936 mn

Gordon Growth Model: There are several ways to estimate a terminal value of cash flows, but one well-worn method is to value the company as a perpetuity using the Gordon Growth Model. The model uses this formula: Free cash flow of the year after the terminal year (Discount Rate –Perpetuity Growth Rate) The formula simplifies the practical problem of projecting cash flows far into the future. Therefore, Terminal Value

Present value of Terminal year

=

13936 × 100 9.5 – 6

=

Rs 146099 mn

=

146099 / (1.095)6

=

Rs. 84754 mn

Calculating Total Enterprise Value: Total Enterprise

=

Sum of Present value for 5 years + Present valueOf Terminal Year + Cash – Debt 42

=

32228 + 84754 + 1949 - 3756

=

Rs. 115175 mn

Fair value

=

Rs 115175 mn

Number of outstanding shares

=

214 mn

Fair value of the HDIL per share

=

Rs 538

SENSITIVITY ANALYSIS Sensitivity analysis is the investigation of how the projected performance varies along with changes in the key assumptions on which the projections are based. The sensitivity analysis of the above DCF model can be done as follows:

Discount Rate

Perpetuity Growth Rate

9%

9.5%

10%

5.5%

596

592

585

6%

533

538

537

6.5%

469

483

489

HDIL IPO Particulars Figures Issue of Equity shares 30,000,000 Equity Shares outstanding prior to the 180,000,000 Issue Equity Shares outstanding after the 210,000,000 Issue Price Band Issue Price Listing Price

Rs. 430 to Rs.500 Rs. 500 Rs. 538 43

3 Days High 3 Days Low Close Price (26th July 2007) DCF Valuation

Rs.634 Rs.535 Rs. 621 Rs. 538

NSE Data

Date

Prev Close Open

High

Low

Close

Total Trd Qty Turnover in Lacs

24-Jul-07 500

538.6

575.95

535

559.35

28590806 160030.8

25-Jul-07 559.35

549.4

587.4

545.3

580.1

8552244 48465.14

26-Jul-07 580.1

585.6

634.3

585.6

621.4

9125757 55976.88

It can be seen that per share value of the HDIL comes to Rs. 538 and the listing price is Rs.538. Close Price as of 26th July 2007 is Rs.621. Hence it is buying opportunity of the investors.

HDIL IPO NEWS TRIVIA:

 According to CLSA, HDIL IPO had been priced at a 20-30% discount to its forward NPV. The IPO is good but the only concern here is the fall in retail demand for property because of high interest rates.

 The HDIL IPO had performed pretty well.

 It had been subscribed by 6.6 times (oversubscribed 5.6 times).

44

 Retail category has been subscribed by only 1.59 times (oversubscribed by 0.59 times).

 Institutional investor category in the HDIL IPO had been subscribed by over 10.13 times (oversubscribed 9.13 times)

 The High Networth Individual category had been subscribed by 1.78 times

(oversubscription ratio: 0.78 times).

PAST IPO PERFORMANCE

45

Equity

Issue Price

Closing Price as on 11/04/2008)

% Gain/Loss

April 2008 Sita Shree Food products Limited

30

43.1

43.67

Gammon Infrastructure Projects Limited

167

164.2

-1.68

March 2008 V-Guard Industries Limited

82

66.95

18.35

Rural Electrification Corporation Limited

105

111.6

6.29

GSS America Infotech Limited

400

410.65

2.66

February 2008 Manjushree Extrusions Limited

45

23.7

-47.33

Tulsi Extrusions Limited

85

76.75

-9.71

IRB Infrastructure Developers Limited

185

182.5

-1.35

Bang Overseas Limited

207

165.1

-20.24

Shriram EPC Limited

300

226

-24.67

Onmobile Global Limited

440

599.6

36.27

KNR Constructions Limited

170

90.7

-46.65

Cords Cable Industries Limited

135

89.55

-33.67

J Kumar Infraprojects Limited

110

91.45

-16.86

Reliance Power Limited

450

361.35

-19.70

Future Capital Holdings Limited

765

561.1

-26.65

46

IPO IN PIPELINE: Open From To

Issue Name 

Offer Price  (Rs.)

Min. Invst (Rs)

47

Aishwarya Telecom Limited

15-APR-08

17-APR-08

32-35

6400

IPO CLOSED BUT YET TO BE LISTED: Retail 

Likely Date of 

Issue Name

Sector 

Cut Off Price

Vimal Oil & Foods Limited Tubeknit Fashions Limited Ammana Bio Pharma Limited

Food Products Textiles Chemicals Printing and Stationery

N/A 108 14

Subscription  (times) N/A 0.17 0.37

45

2.24

N/A

Chemicals

150

2.38

N/A

Engineering

610

0.98

N/A

SVPCL Limited Kiri Dyes and Chemicals Limited Titagarh Wagons Limited

Listing N/A N/A N/A

IPO GLOSSARY

A Allocation This is the amount of stock in an initial public offering (IPO) granted by the underwriter to an investor. 48

Aftermarket Trading in the IPO subsequent to its offering is called the aftermarket.

B Board of Directors The composition of the Board of Directors is particularly critical for an IPO. Typically, a board is composed of inside and outside directors. Broken IPOs If an IPO trades below its IPO price in the aftermarket, it is said to be a broken IPO.

C Calendar This refers to upcoming IPOs and secondary offerings. Brokerage houses have equity calendars, bond calendars and municipal calendars. Clearing Price The price at which all shares of an IPO can be sold to investors in a Dutch Auction. Sometimes referred to as the “market clearing price”.

F First Day Close The closing price at the end of the first day of trading reflects not only how well the lead manager priced and placed the deal, but what the near-term trading is likely to be. Float When a company is publicly traded, a distinction is made between the total number of shares outstanding and the number of shares in circulation, referred to as the float. The float consists of the company's shares held by the general public.

G Green Shoe A typical underwriting agreement allows the underwriters to buy up to an additional 15% of shares at the offering price for a period of several weeks after the offering. This option 49

is also called the overallotment and is exercised when the IPO is oversubscribed and trading above its offer price. The term comes from the Green Shoe Company, which was the first to have this option.

H Hot Issue When there is significantly more demand than supply for an IPO it is said to be a hot issue.

I Initial Public Offering This is the event of a company first selling its shares to the public.

Insiders Management, directors and significant stockholders are regarded as insiders because they are privy to information about the operations of a company not known to the general public. IPO Price Individual investors often ask why the price at which an IPO starts trading is different from its offer price. This occurs because the offer price is set by the underwriters before the stock starts trading. Once the stock starts trading, the price is determined by actual supply and demand and can be higher or lower. IPO Research Prior to the offering, the underwriters involved in the IPO are prohibited from issuing research or recommendations for forty days. Following the IPO, the underwriter is allowed to issue a research report

M-N Market Capitalization The total market value of a firm. It is defined as the product of the company's stock price per share and the total number of shares outstanding

Market Value The market value of a company is determined by multiplying the number of shares outstanding by the current price of the stock. 50

O Offering Price This is the price at which the IPO is first sold to the public. It is set by the lead manager, usually after the close of stock market trading the night before the shares are distributed to IPO buyers. In the case of some foreign IPOs, the pricing occurs over the weekend. Oversubscribed When a deal has more orders than there are shares available it is said to be oversubscribed.

P Preliminary Prospectus This is the offering document printed by the company containing a description of the business, discussion of strategy, presentation of historical financial statements, explanation of recent financial results, management and their backgrounds and ownership. Proceeds Companies go public to raise money. The money raised is referred to as proceeds.

R Red Herring This is the term of art for the preliminary prospectus. It gets its name from the printed red disclaimer on the left side of the prospectus.

U-V Underwriter This is a brokerage firm that raises money for companies using public equity and debt markets. Underwriters are financial intermediaries that buy stock or bonds from an issuer and then sell these securities to the public. Venture Capital Funding acquired during the pre-IPO process of raising money for companies. It is done only by accredited investors. 51

BIBLIOGRAPHY



www.ipohome.com



www.essortment.com



www.investopedia.com 52



www.ipoavenue.com



www.moneycontrol.com



www.wikipedia.com

 www.moneycentral.hoovers.com  www.bullishindian.com  www.rupya.com 

www.investorguide.com

 www.hdil.in/

53