Key factors to consider when evaluating IPO stock prospects

It's important to factor in risk exposure before investing in stocks.

By OH BOON PING

OKAY, so you've come across an IPO that promises a potential yield of 10 per cent next year. As good as that sounds, as a long-term investor, how can you tell if the stock is a real gem and not just a lot of window dressing?

After all, many initial public offerings start out well on the stock market, only to fizzle a few months down the road. To help you suss out companies with real fundamentals from those window-dressed to sell, here are some key factors to look at.

Earnings track record: This is central to any investment decision, as dividends are paid out of net income. The earnings record is also indicative of management's strength. A weak earnings record may reflect the management's inability to grow the business, while a strong track record is always welcome.

However, investors should be aware that financial numbers can be dressed up for an IPO.

The next thing to note is the company's dividend policy since that is key for an investor looking for regular returns.

But a company that doesn't pay generous dividends may have other attractions. If it uses its spare cash to invest in its business for growth, that could enhance the company's value, and stock holders can gain from future share price appreciation.

Growth strategy: It's also important to look at the company's growth strategy since that is indicative of its business direction and earnings prospects. This not only aids in forecasting earnings, but also has an impact on its stock price.

For example, China Milk, which made its debut in 2006, surged by 57 per cent on the first day of trading. Last Friday, it closed at 98 cents - up from its issue price of 62 cents, despite the recent market turmoil.

Obviously, the company's plans to expand its herd of dairy cows, acquire new production facilities and purchase equipment and machinery had received a strong vote of confidence from the market.

Of course, much also depends on the industry the company operates in and its outlook, which brings us to the third factor.

Industry structure and macroeconomic outlook: Here, the things to look for include barriers to entry and market structure.

A dominant presence in the market is an advantage since it gives the company pricing power. Also, high barriers to entry means that there's less chance of its margins being squeezed because of price competition.

One example of an industry leader is Apple, which dominates the MP3 market. Because of the iconic status of Apple's iPod, the firm enjoys greater pricing power compared with rivals like Creative Technology.

Besides the above factors, attention must also be paid to the growth prospects of the overall industry. A company in a sunset industry would post slower earnings growth in the years ahead compared with one that is in a sunrise industry.

Also, a projected economic slowdown may mean sluggish business for the company going forward. This would hit consumer stocks in particular when consumers rein in spending. When that happens, the company's fair value may have to adjust.

Relative valuation: An alternative approach to determine if a stock is cheap or expensive is to compare its price multiple with the median or average of its comparable group of stocks.

This can take the form of price-earnings (P/E), price-book (P/B) or price-cash flow (P/CF) ratios, even though PE is probably the most widely used measure here.

For example, United Test & Assembly Center (Utac) was once trading at a P/B of 1.4 times for 14 per cent return on equity (ROE) compared with Stats ChipPAC's P/B of two times for 6 per cent ROE.

This was also lower than P/B of 2.7 for the semicon assembly and test sector as a whole. Little wonder then that Utac was deemed to be cheap and has since been bought over a private equity group.

Risk factors: Not to be forgotten are the business risks that the company faces. Finance 101 teaches us that higher returns are accompanied by higher risks. And prudence dictates that an investor factors in the risk exposure before deciding if a stock is a good buy.

For a biomedical firm, for example, risks include the high failure rate in its research efforts, while a structured finance fund is exposed to default risk in its underlying debts.

An example is the Babcock & Brown Structured Finance Fund, which promised a yield of 9 per cent at IPO in 2006. At that time, roughly a third of its portfolio was allocated to assets like loan portfolio and securitisation such as collateralised debt obligations (CDOs).

It is difficult to assess the risk characteristics of CDOs since much depends on the seniority of the tranche. Complicating the picture further is the fact that the default of one underlying party may result, to different degrees, in the default of other parties in the portfolio.

In short, it is important to understand the types and amount of risk exposure in a stock before making your investment decision.

Source: BT Online