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The benefit of IPO grading

In response to the Money Today story on how rating of IPOs has been of little help to retail investors (Read 'Do We Need IPO Grading?') Crisil’s Arun Panicker argues that grading helps if investors know where exactly it belongs in their investment decision process.

Arun Panicker        Print Edition: September 4, 2008

In response to the Money Today story on how rating of IPOs has been of little help to retail investors (Read 'Do We Need IPO Grading?') Crisil’s Arun Panicker argues that grading helps if investors know where exactly it belongs in their investment decision process.

Crisil launched the grading of initial public offerings (IPOs) in mid-2007. It is still relatively new and the first time that a product of this nature has been introduced globally. Investors, therefore, need to understand what the product is, how to use it correctly and, more importantly, take empowered, informed decisions to derive the maximum value from it.

An IPO grade reflects Crisil’s opinion on how strong the company offering the IPO is on fundamental parameters—business prospects, financial performance, management capability and corporate governance— compared with other listed Indian companies. In other words, it is an expert opinion on the “quality” of the company. Crisil assigns grades on a scale of 1 to 5, the last being the highest grade. Investors can view the grades on our Website www.crisil.com. The grade will also be displayed in the company’s IPO prospectus, advertisements and application forms.

Crisil believes that as an investor you need to answer three questions before deciding to invest in an IPO. Firstly, how strong is the company on the fundamentals? Secondly, is it being offered at the right price? Finally, is this the right investment for you? The answers to these questions will help you take investment decisions that are tailored for you, rather than going only by the traditional “buy”, “hold” and “sell” recommendations, which are more generic in nature.

So, what should you do once you know Crisil’s IPO grade? If you visit Crisil’s Website, you can read the rationale and analysis underlying the grade. The rationale is easy to understand. The investors will find that over time it improves their understanding of companies and their sophistication as investors. Next, you will need to go through the remaining two legs of the analysis— determining whether the price at which the IPO is being offered will enable you to get returns, and whether this investment is appropriate for you. Initially, you may think it is a lot of additional work, but after you have gone through this process a few times, it becomes quite simple. The quality of your decision-making as an investor certainly improves.

IPO grading and investment decision

Analysis of fundamentals

Analysis of returns

Investor preference

Crisil IPO grading helps you with analysis of fundamentals

IPOs Graded (since 1 April 2008)

CompanyGrade
MCX of India5
Virgo Engineers4
Nu Tek India3
Ramky Infrastructure3
RITES Limited3
Microsec Financial Services2
Neoteric Infomatique2
VRL Logistics2
Shankara Pipes India2

• Out of the nine IPOs that have been graded since the beginning of the financial year 2008-9, only one, MCX, has been awarded 5, the highest grade

• The most commonly awarded grade is 2, with four IPOs being rated so. Three IPOs have been given grade 3

• None of the IPOs has been awarded grade 1, which is the lowest grade on the scale

So far, investors have been accessing research material on IPOs that concludes with a “buy”, “hold” or “sell” recommendation. In contrast, an IPO grade is neither an opinion on the issue price, nor a recommendation to buy, sell or hold the shares. It is also not an opinion on the shares’ future market prices or their suitability for a particular investor. In other words, as an investor, you should not use the IPO grade for assessing if the IPO’s price is right. For this, there are numerous other tools that are used widely, among them a comparison of the price/earnings (P/E) ratio with that of other companies in the same peer group, and analysis of the P/E to growth ratio.

The grade does not indicate how many times the issue will be subscribed. This depends on factors such as liquidity and market sentiment, which are unrelated to the fundamentals of the company. Also, the grade gives no indication of the price the issue will open at, or the likely returns. Technical factors can weigh heavily on opening prices, and the returns will depend on investment time horizons. Finally, the grade by itself does not tell you whether the IPO is a suitable investment for you; that depends on your age, the composition of your current investment portfolio, family situation and requirement of money. A good financial adviser is the best person to help you with this.

Crisil is often asked, what is the value of a product that provides only limited answers? Imagine walking into a television showroom to buy an expensive and sophisticated plasma TV. You face a wall full of TVs of different brands and sizes. Would you not like an unbiased opinion that brand ‘X’ is better than brand ‘Y’ because it has better features, a better picture and better sound? Having received this opinion, you can decide which plasma TV to purchase depending on your budget and any other criteria you have in mind. The choice is yours, but having an expert opinion on the quality from someone you can trust certainly improves your decision-making.

This unbiased opinion on quality that the TV expert gives you is exactly what an IPO grading offers you in the equity space. By virtue of its credibility and unparalleled experience, of evaluating over 4,000 managements and businesses over the past 20 years, Crisil can give you a robust and reliable analysis on the quality and prospects of the company.

Arun Panicker is Senior Director, Crisil

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