IT IS important to note that as a serious investor, you should participate in an initial public offer (IPO) only if the company 'going public' is an excellent
business with long-term growth potential.
But what makes an excellent business? This week, we examine the fundamentals and measures of an excellent business.
INDUSTRY AND COMPANY GROWTH PROSPECTS
Look at the industry in which the company operates. Review the
historical growth and performance as well as the projections for the future. Examine whether there is strong demand for the product. Is this demand sustainable over the long term?
At this point, look at whether the company operates within a protected environment. This protection may be due to government regulations such as high import duties for
external competitors.
For example, Caribbean Cement Company Limited operates in a regulatory protected industry, as competitors such as Mainland Cement are subject to 40 per cent import duties.
Other barriers may be due to the high levels of capital required to start up and special licenses required to operate. These restraints restrict the ease with which a company may enter an industry to compete with current players.
A company operating in a positive environment and industry that experiences growth, has the ability to improve and widen its product and service offerings; increase its market share; grow its business, expand its profits while passing on these
benefits to its shareholders through dividends and capital appreciation.
RESPECTED MANAGEMENT TEAM
In looking at the company itself, look at the backbone of the company its management.
Excellent companies have
excellent leaders. Quality leadership characteristics include respect within the industry and outside of the industry; extensive experience in the field; responsiveness to industry, market and economic changes in society; creative ability to do something others never thought of; and a documented vision to take the company to the next level. Simply, what sort of person heads the company issuing the IPO?
SOLID FINANCIALS
After looking at management, view the operations of the company.
Here we pick apart the numbers. The financial statements of the IPO will give the relevant data required to understand the financial fundamentals.
Note that the fundamentals are generally expressed as ratios or
per centages that allow ease in comparing the IPO to other
companies in the same industry. Of the many ratios and per centages one can calculate, we now look at a select few.
Price earnings ratio: First we look at the price earnings ratio (P/E). This is the price of the stock divided by the earnings per share.
The earnings per share are the net profit divided by the number of shares. This tells you how much investors must pay for each dollar the company earns. And the lower the number, the better.
A benchmark figure is 15 times expected earnings. Why? Because the higher the P/E, the faster the market expects the profits of the company to rise. And it is preferable to see a steady rise in profits over the long term. No company can sustain a meteoric rise in profits over the long term.
Additionally, do not just look at the P/E of one year. Take the time to look at the last five years and consult your wealth manager on the projections for the near future.
Price earnings to growth ratio: Next, we look at the price earnings to growth ratio (PEG).
Here, you divide the P/E ratio and your wealth manager's projections of percentage earnings per share growth over the next five years. Analysts state that PEGs less than one are considered a bargain. Why? Because the current share price is valued at less than what the company is projected to grow to in the next five years.
Gross margin: From there, we look at the company's gross margin. Here, we take the money made on its sales minus its basic costs and multiply by 100. That percentage should be high.
Companies with low gross
margin percentages spend too much money for each dollar of sales. These companies should be avoided.
Return on equity: Next, we look at the return on equity. This ratio demonstrates management's ability to efficiently grow the capital invested in the company. This is found by dividing net earnings by stockholder's equity. In this case, the larger the number, the better.
Debt to equity ratio: And finally, we look at debt to equity. This number should be low as it measures how well management uses debt to grow the value of the company. It also indicates that the company is not heavily leveraged and therefore is flexible to take advantage of lucrative investment opportunities. This percentage is found by dividing long-term debt by shareholders equity.
READ COMPANY'S PROSPECTUS
The numbers and information about the company can be found in the prospectus.
Besides accessing the expertise of your wealth manager, it is advised to read the company's prospectus. This is the document that is legally required to be
distributed by the company doing an IPO. And as a final clue to the excellence of the business, the IPO discusses the future plans of the business.
With the assistance of your wealth manager, you can determine if the future plans demonstrate a solid, sustainable business strategy.
