Do we need IPO grading?

Rating of companies coming out with IPOs doesn't help investors because it doesn't focus on the issue price.

Tanvi Varma/Money Today | Print Edition: July 10, 2008

AA, AAA, A+…Grades such as these are assigned by rating agencies to most financial instruments based on several parameters. Even if you don’t understand why these grades have been given, you do know that the better the grade, the higher the chances of good returns. So, when Sebi made it mandatory for companies to have their initial public offerings (IPOs) graded, it sounded like a great idea. The higher the grade, the better the IPO’s prospects; or so we thought. Sadly, we were wrong. The grades do not reflect the future performance of the issue in the stock market.

Consider this. Both Allied Computers and Orbit Corp were given grade 1, the lowest grade. But Allied shares have risen 75% over their issue price, while Orbit has risen almost 330%. Gammon Infrastructure, however, got a high grade of 4. The stock is now 4% less than the issue price. What does this mean? It means, quite simply, that the IPO grade does not rate the offering; it only rates the company.

The grades reflect only the company’s fundamentals and not the future performance of the issue. A look at the table below almost proves a contrarian’s point—the lower the grade, the better the performance. Of course, you know that judging a stock is not the only way to long-term wealth creation. As Warren Buffett says, you’re not buying a stock; you’re investing in a business. That’s where the so-called IPO grading can help. It tells you how sound the company’s fundamentals are—a grade of 5 means strong fundamentals, and 1 is the poorest.

Terming the rating an “IPO grade” is misleading. If the grading were to try rating the issue itself, it should take into account the price at which the shares are offered. In its current form, the grading just assesses the company and its prospects without stating whether the shares being offered are worth their price or not. “Grading without factoring in the price is meaningless. A good company at a high price is a bad investment,” says Prithvi Haldea, MD, Prime Database.

“Pricing of shares is the most critical factor in evaluating IPOs and by not taking pricing into consideration, the usefulness of grading is diminished,” adds Mridul Sagar, chief economist, Kotak Securities. As Amar Ambani, vice-president (research), India Infoline, says, “We may not promote the IPO despite a good grading if it is at an unjustifiably high premium.”

"Grading IPOs without factoring in the price is meaningless. A good company at a high price is a bad investment."

Prithvi Haldea, Managing Director, Prime Database 

Grading scale

4Above average
2Below average
Four independent rating agencies— CARE, ICRA, Crisil and Fitch—grade a company on various parameters, including its position in the industry, its business prospects and its financial strength. “Equityrelated financial parameters for the graded company, such as the return on equity and EPS growth, are compared with the broader universe of listed companies,” says Arun Panicker, senior director, Crisil.

There is also a qualitative assessment of the management, corporate governance and litigation history. So, the grade summarises the voluminous data in the prospectus and its implications, which a lay investor may not be able to comprehend on his own. “Grading by independent agencies is meant to introduce the first line of check so that investors can differentiate the good floats from the risky ones,” says Sagar.

If the grading only reflects the fundamentals of the company, why has Sebi made it mandatory? After all, the regulator examines the red herring prospectus before giving the issue its approval. More importantly, the underwriters to the issue examine every minute detail thoroughly. Given this, adding one more layer to the same process seems a bit of a waste.

Apart from not helping investors make a choice, the grading process might end up stifling the IPO dreams of small enterprises. If a good company is given a poor rating, it may shelve its IPO plans. For instance, a small-cap stock could get a poor grade as most rating agencies treat small enterprises with scant respect.

“The grading, by its design and given our psyche, is biased against small issuers,” says Haldea. However, Panicker defends the grading procedure saying that it is not supposed to tell whether or not to invest in an IPO. “Grading is not a recommendation on the security,” he says. On its website, Sebi also notes: “An IPO grade is not a suggestion or recommendation as to whether one should subscribe to the IPO. IPO grade needs to be read together with the disclosures made in the prospectus as well as the price at which the shares are offered.”

The grading could aid institutional investors, who, as Sagar says, “have a better understanding of the IPO grading process. They are also more aware of the limitations of the grading process”. The grade could also help when there is limited information available on the IPO, which happens in case of small issues.

Armed with this information, we leave you with a teaser. MCX, the country’s largest commodity exchange, plans to go public soon. Its IPO grade, from Crisil, is 5—the highest any company can get. Will you subscribe to the offer based on this? Write in and let us know.

 How some graded IPOs have performed

Varun Industries131 Oct 2007606812.5%
Allied Computers International (Asia)123 Oct 20071225105.4%
Saamya Biotech (India)1
28 Sep 2007 10 8.7 -12.7% 
Ankit Metal & Power122 Jun 200736
Celestial Labs122 Jun 20076048-19%
Orbit Corporation123 Mar 2007110463320.6%

Gammon Infrastructure Projects413 Mar 2008167145-13%
IRB Infrastructure Developers45 Feb 2008185188-1.7%
OnMobile Global429 Jan 200844060537%
Reliance Power418 Jan 2008450191#-18%
Precision Pipes & Profiles Company4
20 Dec 200715082-45%
Transformers & Rectifiers India412 Dec 2007465384-17.5%
Jyothy Laboratories427 Nov 2007690504-27%
Edelweiss Capital420 Nov 2007825673-18%
* Price as on 17 June; # Adjusted for 3:5 bonus issue

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