New issues

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7. What to look for in the prospectus (2) - standard company analysis

Nearly every company coming to market for the first time has a growth story to tell investors. Sometimes that story is justified, sometimes not. Your mission, should you choose to accept it, is to distinguish between the two before you risk your money.

You can do a rough and ready check by calculating the growth rates in sales and earnings from the prospectus and comparing them with those of direct competitors. Five-year figures for individual companies are available free of charge at Hemscott.net.

If the growth rates for a new-issue company are much higher than the sector norm, be on your guard. The most calamitous IPOs are usually those that occur after a burst of strong, unsustainable growth that allows the directors and their advisors to place an artificially high valuation on the company. When this inevitably tails off, the share price collapses.

Remember: extraordinary growth needs an extraordinary explanation.

Ask yourself whether the company has some unusual competitive advantage, such as

• patents, trademarks or unique distribution licences
• strong, well-recognised brands
• dominance in particular regions or countries
• a dominant share of its chosen market(s)
• the lowest-cost production in its sector
• ultra-efficient distribution networks
• outstanding marketing and sales divisions
• a clear lead in research or technology.

If it has few or none of these things, the growth is likely to prove temporary or even illusory, a result more of accounting techniques than business performance. Subject any growth forecasts or 'illustrative financial projections' to the same tests. They too must look realistic when compared with those elsewhere in the sector.

Even if a company looks like a genuine growth prospect, it does not follow that its IPO represents value for money. So your next step should be to check the key ratios against those of its competitors:

Price-to-earnings ratio (P/E)
Ideally, the offer should be rated at some sort of discount, to allow for expansion of the P/E multiple after flotation. If it is being sold at a premium, that certainly needs to be reflected in superior and sustainable growth prospects.

Price-to-earnings-growth ratio (PEG)
This is more important than the P/E alone. Even if the P/E is relatively high, you may still be looking at a worthwhile investment if the prospective PEG is less than 0.75, i.e. the forecast earnings growth rate exceeds the forward P/E by one-third or more. Beware, though, if the forward P/E is above 30 - multiples that high are much harder for companies to maintain.

Price-to-sales ratio (PSR)
This is rarely a problem, particularly if sales growth is very rapid. A PSR of 3-5 is not unusual for an established growth company. But once it gets above 6, you should check that it is satisfactorily supported by high and stable margins and strong sales growth.

All these guidelines apply only to growth investment. The very nature of IPOs virtually rules them out for value investors. The kind of bargains they seek are, almost by definition, only ever going to be found in the open market after investors have temporarily lost faith in a company's future prospects. Indeed, their only obvious reason for taking an interest in IPOs is in order to spot those that fail disastrously, allowing them to pick up companies on the cheap.

1. After Sid - a short history of the new issues market 2. Do new issues offer good value? 3. Types of new issue 4. Applying via brokers and intermediaries 5. The prospectus 6. What to look for in the prospectus (1) - directors and advisers 7. What to look for in the prospectus (2) - standard company analysis 8. What to look for in the prospectus (3) - blue-sky company analysis 9. Making your application 10. Stagging 11. A word on warrants 12. A tale of two issues 13. Conclusion

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