Look beyond IPO grading when investing in shares of companies

It has been about four years since grading of Initial Public Offerings (IPOs) was made mandatory through an amendment of the SEBI (Disclosure and Investor Protection) Guidelines, 2000. IPO grading, expressed on a five-point scale, is essentially a comment on the fundamentals of an issuer. A rating of one indicates poor fundamentals and five strong fundamentals.

What does analysis of fundamentals actually involve? The emphasis of an IPO grading exercise is on evaluating the prospects of the company's industry, the firm's strengths that would allow it to address risks of the business and its financial position. If IPO proceeds are to be used to set up projects, either greenfield or brownfield, the evaluation changes. The risks inherent in the project, the capacity of the management to execute them, and the benefits accruing from the successful completion, in terms of profitability and returns, are considered. Due weightage is also given to the issuer's management strengths, weaknesses and corporate governance issues.

Of course, IPO grades are not a comment on the issue price, valuation or possible gains through price appreciation. Consequently, the exercise of IPO grading does not take price into account at any stage. Neither is it a recommendation to buy, sell or hold shares of company stocks that have been graded.

IPO grading is not a recommendation to buy shares of companies that have been graded but a comment on the fundamentals of the firm.

There are a few basic reasons why IPO grading is necessary. An investor in a hitherto unlisted company may either have limited access to information on it or may find it challenging to appropriately assess the company, on the basis of the information available, its business prospects and risks. An IPO grade provides an additional input for investors to arrive at a decision based on independent and objective analysis.

In recent times, with stock market participation of new and foreign investors increasing, there is need for greater value-added information on companies tapping the capital market and their intrinsic quality. In this context, IPO grades, being simple, objective indicators of the relative fundamental positions of the issuers concerned, could help in both widening and deepening the market.

The benefits notwithstanding, the debate on the relevance of IPO grading refuses to die down. The debate is intensified whenever the price of a scrip slips below the IPO price, an IPO gets withdrawn after grading or a highly-graded IPO does not do well on the bourses. These are facts that cannot be contested.

But do they make IPO grading irrelevant? Certainly not. This is because IPO grading does not comment on the valuation or pricing of an issue. Also, the price being a market function, it is entirely possible for highly-graded IPOs to do badly on the bourses, especially if the valuations were aggressive and the market on a downward slide or vice-versa.

Overall, the basic purpose of grading is to serve as an additional input, which is independent and arrived at through a rigorous analytical process, to aid an investor's decision in subscribing to an IPO. Now, what weightage an investor assigns to an IPO grade given to a stock is a matter of individual judgement.

ANJAN DEB GHOSH
Group Head, Corporate Sector Ratings, ICRA

YOUR GUIDE TO UNDERSTANDING MARKETS
1.	It's Bull v/s Bear on the stock markets
2.	Market volatility tests investor patience
3.	'Lacklustre trading to continue for some quarters'
4.	'Firms with good management deliver well on bourses'
5.	Invest in stocks with sound fundamentals
6.	Pick the best IPO to invest in
7.	Check grades before investing in IPOs
8.	'Look beyond grading when investing in firms'
9.	8 Deadly Sins of Investing
10.	'Widespread investment by people will lift the market'
11.	Expected mixed response to MII report: Bimal Jalan