PART I: How to make money in IPOs
PART II: Understanding IPO jargon
PART III: 3 wrong reasons to opt for an IPO

In the earlier piece, we gave you three reasons why you should not invest in an IPO. Over here, we tell you how to ensure you are getting the IPO at a right price.

It is not that confusing. You only have to do a bit of calculation before you take the call.

Where do you begin?

Start by calculating the PE ratio.

What is the PE ratio?

Price-Earnings ratio = Market price of the share / EPS

What is the EPS?

Earnings Per Share = net profits / total number of shares

How will you calculate the PE if you do not know the price of the stock?

When companies put up their shares for bidding, there is normally a price range (read IPO terms you must know). For instance, the face value of the shares may be Rs 10 but they will be quoted at a premium of Rs 700 to Rs 900 per share.

In such a case, you calculate the PE with both these ranges. One PE will be got assuming Rs 700 as the market price and the other using Rs 900 as the market price. (To understand market price, read How to make money in IPOs).

Now that you have the PE, compare it with other companies in that sector.

If the PE is in line with other comparable companies in the industry, then the price is on track.

Generally, a lower PE ratio stock is much sought after; it indicates there is room for growth.

Most current IPOs are richly priced, as companies take advantage of the red-hot market. A recent example of a high priced IPO was the Jagran Prakashan issue. However, Royal Orchid's was fairly priced in comparison to that of peers such as Taj GVK and Asian Hotels [Get Quote].

Dig further

In the prospectus (a document which details all information about the issue), the section 'The Issue' gives details about the number of equity shares of the company, the number of new shares being issued, the number of shares to be available to retail investors and so on.

The important thing here is to determine the extent of dilution. 

What's dilution?

Suppose a company had 100,000 shares and it issues 20,000 new shares in the IPO. The dilution is then 20% (20,000 / 100,000).

Why is dilution important?

You'll find a section in the prospectus called 'Basis for issue price'. This gives the EPS of the company for the last few years.

The company then takes the price band at which it is issuing the shares to arrive at the PE at which the offer is being made.

What you should do is take the diluted EPS, ie adjust the EPS for the new shares being issued. Then compute the PE, which will obviously now be higher. Now, compare it with other companies in the same industry.

Let's take the example of Sadbhav Engineering [Get Quote].

Net profits for the year ended March 2005 = Rs 738.83 lakh (Rs 73.8 million)

Number of shares on that date = 80 lakh (8 million) 

Earnings Per Share = 738 / 80 = Rs 9.225

After the issue, the number of shares will go up to 109 lakh (10.9 million)

Diluted Earnings Per Share = 738 / 109 = Rs 6.77

At the higher end of the price band (Rs 185), the PE works out to 27.3 (185 / 6.77), based on 2005 earnings per share. As the prospectus points out, the average PE for the industry is 27.

Making the final call

Of course, what matters is the prospects of the company rather than past history. But, in the absence of reliable forecasts, comparing the historical PE with that of other companies in the industry will give you a idea of whether the issue is richly valued.

Also compare book value, net worth [assets (what it owns) - liabilities (what it owes)] with other companies in the same industry.

It's not wise to subscribe to IPOs at high valuations. The whole point of applying for IPOs, after all, is to try and get the shares cheaper than the listing price. Otherwise one could easily pick it up from the secondary market post-listing -- why go through the hassle of applying for the IPO, waiting for allotment and so on?

PART I: How to make money in IPOs
PART II: Understanding IPO jargon
PART III: 3 wrong reasons to opt for an IPO