Curiously enough, I have watched several public offerings in India. There was a lot of IPO fever during 2005 and 2006. Almost every stock gave 50% returns on the day of listing. Some shares broke all records, one of the examples is of Indiabulls which has had a dream run since the time it listed around Rs. 19 per share.
The heat also led to some FPOs coming out around that time which really did not perform that well. Some burnt the investors really hard, while some others also managed to do well. Jindal Polyfilms was such an FPO which made it impossible to recover the money of investors. It had a dream run prior to the FPO though.
A well known theory in finance is called Pecking Order theory which states that unless a company really has a very good reason to come up with an FPO, it should never do so. If a company does FPO without convincing reasons, it projects itself in really bad light.
There are three main ways to raise money:
- Internal financing
- Raising debt
- Offering equity
The theory simply states that firm should always try to raise money in the above order. Offering equity should only be taken as a last resort. Let me provide an example why FPO projects a company in bad light.
Think about the reasons why a company would sell equity if either internal cash or debt is available. The only major reason is that the shares are overvalued. That is why raising from equity is more profitable than raising from other resources. Consider that the true value of a share of the firm is Rs. 10. If the actual market price is Rs. 15, then company knows that its shares are overvalued. But the outside investors do not know this fact. In this case, if company does FPO, it will give Rs. 10 worth of equity to get Rs. 15 from the investors. Not a bad deal at all... instant profit of 50%.
However, if the market price is Rs. 5, the internal managers of the company know that shares are undervalued. So the company will never come out with an equity offering because it will give out Rs. 10 and take Rs. 5, a loss of 50%. No company will ever do that.
So next time, if a company which is already listed in the market comes out with a public offering, be alert and read carefully why the company is offering equity. Try to find answers about why the company is not using its internal cash or bank debt. Only when you are fairly sure that equity offering is the best route, you should invest in the FPO.