Grading of an IPO

The grading of an initial public offer (IPO) is a new product, launched in mid-2007 by CRISIL. It is the first time that a product like this has been launched anywhere in the world. It is important for investors to understand how to use the product correctly, so that they can derive best value from it. Properly used, IPO grading can empower you, the investors, to take considered and informed investment decisions.

An IPO grade reflects CRISIL’s opinion on how strong the company making the IPO is on fundamental parameters, business prospects, financial performance, management capability, and corporate governance compared with other listed Indian companies. In other words it is an expert opinion on the “quality” of the company. CRISIL makes IPO grades available free of charge to all investors. You will see the grades displayed in the company’s IPO prospectus, advertisements, and application forms. The grades are assigned on a self-explanatory scale, from 1/5 to 5/5, with 5/5 being the highest grade.

Investors have been getting equity research and research on IPOs that conclude with a simple “Buy”, “Hold” or “Sell” recommendation. An IPO grade, by contrast, is neither an opinion on the issue price, nor a recommendation to buy, sell, or hold the shares. It is also not an opinion on the shares’ future market price or their suitability for a particular investor. In other words, as an investor you should not use the IPO grade to assess whether the price of the IPO is right. For this, there are numerous other tools that are commonly used, among them a comparison of the price/earnings (P/E) ratio with that of other companies in the same peer group, and analysis of the P/E to growth ratio.

The grade is no indication of how many times the issue will be subscribed. This depends on factors such as liquidity and market sentiment, which are unrelated to the fundamentals of the company. Thirdly, the grade gives no indication of the price at which the issue will open, or the returns that are likely from the issue-technical factors can weigh heavily on opening prices, and returns will depend on investment time horizons.

And lastly, the IPO grade by itself does not tell whether the IPO is a suitable investment for the investor. That depends on investor’s age, the composition of his or her current investment portfolio, family situation, and requirement of money. A good financial advisor is the best person to help you with this.

CRISIL believes that, an investor needs to answer three questions before deciding to invest in an IPO. Firstly, how strong is the company on fundamentals? Second, is it being offered at the right price? And third, is this the right investment?

Clear answer to each of these questions will help you make investment decisions that are tailored for you individually, rather than going only by the traditional “buy”, “hold” and “sell” recommendations that are more generic in nature.

So, what should you do once you have CRISIL’s IPO grade? If you visit CRISIL’s website, you can read the rationale and analysis underlying the grade. The rationale is easy to read and understand. Over time, investors will find that it improves their understanding of companies and their sophistication as investors. Next, you will need to carry out the remaining two legs of the analysis determining whether the price at which the IPO is being offered will enable you to get returns, and determining whether this investment is appropriate for you. Initially, it may seem like a lot of additional work, but once you go through this process a few times, it becomes quite simple. And the quality of your decision making as an investor certainly improves.

At CRISIL we are often asked, “What is the value of a product that provides only limited answers?” Imagine that you walk into an electronics shop to buy something expensive and sophisticated like a plasma TV set. You stand in front of a wall of TVs of different brands and sizes. The buyer would need an unbiased opinion that brand X is better than brand Y because it has better features, better picture quality, and better sound. Having got that opinion, he can then decide which set to buy, depending on his budget and any other criteria he has in mind. The choice is of the buyer but having the expert opinion on quality from someone he can trust, certainly improves buyer’s decision-making.

The unbiased opinion on quality that the TV expert would give in this example is exactly what an IPO grading offers an investor with regard to equity. CRISIL has 20 years of experience in evaluating more than 4,000 managements and businesses. It is thus able to give robust and reliable analyses of the quality and prospects of the company.