PART I: How to make money in IPOs
PART II: IPO terms you must know
PART III: Wrong reasons to invest in an IPO
PART IV: How to invest smartly in IPOs

Most Initial Public Offerings these days are done through the book-building method.

Book building is the process of price discovery. The company does not come out with a fixed price for each share. It fixes it through the book building process.

In such cases, what the company comes out with a price band. The lowest price is referred to as the floor and the highest, the cap.

These figures are not arrived at randomnly; they depends on parameters such as the net worth of the company, its earnings per share, the prospects of the business and the market conditions.

Taking these factors into consideration, the issuing company, in consultation with its merchant bankers to the issue, first fixes a price band. This price band is indicated on the prospectus (a document that contains all the details of the issue).

Investors are then invited the bid for the shares. They state their price and the number of shares they would like at that price. Accordingly, the right price is 'discovered'.

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Here's how it works

Three classes of investors can bid for shares:

1. Qualified Institutional Buyers: They buy 50% of the issue. Out of this 50%, upto 5% has to be allocated to mutual funds.

2. Retail investors: 35% of the issue

3. High networth individuals and employees of the company: 15% of the issue

The book running manager or chief merchant banker, on receipt of the offers, maintains a record of the names, the number of shares ordered and the price of the bids.  

After the bidding is over, the issue price is fixed based on the bids received. This is called cut-off price.

All bidders who have quoted above the cut-off price are entitled for allotment.

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Working it out

Let's say a company is coming out with an IPO of 4,000 shares and the price band is fixed at Rs 30 to Rs 36 per share.

The bidders can bid at any price within the price band. Seven bids have come in.

Bid price	Number of shares bid for	Percentage of total shares	Cumulative shares bid
Rs 36	1,000	25%	1,000
Rs 35	1,500	62.5%	2,500
Rs 34	500	75%	3,000
Rs 33	1,000	1000%	4,000
Rs 32	1,500	137.5%	5,500
Rs 31	2,000	187.5%	7,500
Rs 30	2,500	250%	10,000

The price discovery is a function of demand at various prices.

Let me explain. 

The highest price at which the company able to issue the desired number of shares is the price at which the issue is subscribed. In the above example, Rs 33 per share (or lower) will be the cut-off price.

The reason? Including all the bidders up to Rs 33 per share will ensure the 4,000 shares will be sold.

If Rs 33 is the cut-off price, those who bid for less than Rs 33 will not be allocated any shares. Those who bid at Rs 33 or more will get the shares at Rs 33 each.

Most companies leave the issue price below the highest cut-off point so there is some scope for price appreciation for the investor. In the above example, if the cut-off is fixed at Rs 30, the issue will be oversubscribed 2.5 times and proportional allotment will have to be made.

This is all very transparent and you can see a graphical representation of the consolidated demand and price on the Bombay Stock Exchange and National Stock Exchange Web sites. You will also see it at the bidding centres during the bidding/ issue period (these centres will be listed in the Prospectus).

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How to make it work for you

You can put in bids in the names of your family members too. You will, however, need to open a demat account for them first.

Also, if the issue is being oversubscribed (you can find out on the stock exchange websites mentioned above), increase the number of shares you want. For instance, if you want 100 shares and feel the retail portion of the issue will be over-subscribed three times, you should bid for 300 shares.

When the bookbuilding process starts, don't apply for an IPO on the first day itself -- check how the demand builds up.

If the institutional interest is large and retail interest is muted, you stand a good chance of getting an allotment.

Also, if the institutions don't get the shares they want, they will pick it up when the stock gets listed. This unsatisfied institutional appetite will mean that the stock price will go up after it is listed.

PART I: How to make money in IPOs
PART II: IPO terms you must know
PART III: Wrong reasons to invest in an IPO
PART IV: How to invest smartly in IPOs