Chapter 3 : Primary Markets : IPO - Introduction
PRIMARY MARKET :IPO
In the previous chapter we have covered stocks or shares extensively. We have also briefly explored the difference between primary and secondary markets. Now let us learn more about each one of them. In this chapter we shall look at primary markets. We have already seen that a primary market is the place where new offerings by companies are made as an Initial Public Offering (IPO). IPOs are offerings made by the company for the first time. You must have already seen many a times new IPO campaigns. One recent IPO which made major headlines is that of Reliance Power.
Such an off er to the public can be at par or at a premium. The pricing of the issue depends upon the current status of the company and the company is allowed to fix a jusifiable issue price. We have seen earlier why money is so important for the new business and how issuing a share, i.e selling part of their company to equity holders in the form of shares, can change the business prospects of the companies. Let us look at the whole process with an example to understand how stocks are issued.
We know that almost every large corporation had a humble beginning and gradually became financial giants. Infosys is one such example. It was established by Narayana Murthy and six engineers in Pune in 1981 with an initial capital of USD 250. But look at Infosys today. It is a NASDAQ-listed global consulting and IT services’ company with more than 90,000 employees. From that meagre capital the company has grown to become a USD 4 billion company.
When a company is growing, the biggest hurdle it faces is raising enough money to expand. So owners generally have two options. They can either borrow the required money from a bank or sell a part of the business to investors and use the money to fund growth. To understand how issuing stock works in a better way, let’s look at a fictional company called XYZ Furniture. After getting married, a young couple decides to start a business on their own. It would allow them to work for themselves, as well as arrange their hours around their family. This is a natural decision for any person with an entrepreneurial mindset.
Both husband and wife have always had a strong interest in furniture and so they decide to open a store in their hometown. After borrowing money from the bank, they name their company XYZ Furniture and go into business. During the first few years the company makes a little profit. The earnings are, however, ploughed back into the store to buy additional inventory and make additions to the building to accommodate the increasing pace of business.
Ten years later, the business has grown rapidly. The couple has managed to pay off the company’s debts and profits are over Rs 5,00,000 a year. Convinced that XYZ Furniture could do as well in several larger, neighbouring cities, the couple decides that they want to open two new branches. They research their options and find out it is going to cost over Rs 40 lakhs to expand. Not wanting to borrow money and be strapped with interest payments again, they decide to sell stock in the company.
The company approaches an underwriter such as Goldman Sachs or J P Morgan, who determines the value of the business. As mentioned before, XYZ Furniture earns Rs 5,00,000 as after-tax profit each year. It also has a book value of Rs 30 lakhs (the value of the land, building, inventory etc out of which is subtracted the company’s debt). The underwriter researches and discovers that the average furniture stock is trading at 20 times the earnings.
What does this mean? Simply that you would multiply the earnings of Rs 5,00,000 by 20. In XYZ Furniture’s case, this works out to Rs 1 crore. Add the book value and you arrive at Rs 1.3 crore. This means, in the underwriter’s opinion, that ABC Furniture is worth Rs 1.3 crore. Our young couple, now in their 30s, must decide how much of the company they are willing to sell. Right now they own 100 per cent of the business. The more they sell, the more is the cash they will raise. However, they will also be giving up a large part of their ownership. As the company grows, that ownership will be worth more and so a wise entrepreneur would not sell more than he or she has to.
After discussing the issue with the right people, the couple decides to keep 60 per cent of the company and sell the other 40 per cent to the public as stock. This means that they will keep Rs 78 lakh worth of the business. Because they own a majority of the stock, they will still be in control of the store. The other 40 per cent they sell to the public is worth Rs 52 lakh. The underwriters find investors who are willing to buy the stock and pay the couple Rs 52 lakhs.
Although they now own less of the company, their stake will hopefully grow faster since they have the means to expand rapidly. Using the money from their public offering, XYZ Furniture successfully opens two new stores and has Rs 12 lakh in cash left over. Business is even better in the new branches since they are in more populated cities. Each of the stores makes an annual profit of around Rs 8,00,000 while the old store still makes an average of Rs 5,00,000. Between the three stores, XYZ now makes an annual profit of Rs 21 lakhs.
This is great news because although they don’t have the freedom to do business the way want to the business is now valued at Rs 5.1 crore (multiply the new earnings of Rs 21 lakhs per year by 20 and add the book value of Rs 90 lakhs since there are three stores now instead of one). The couple’s 60 per cent stake is worth Rs 3.6 crore. With this example it is easy to see how small businesses seem to explode in value when they go public. The original owners of the company become, in a sense, wealthier overnight.
Earlier, the amount they could take out of the business was limited to the profit. Now, they are free to sell their shares in the company at any time and thus raise cash quickly. This process is the basis of the functioning of Dalal Street. The stock market is, at its core, a large auction where ownership in companies like XYZ Furniture is sold to the highest bidder each day. When we buy the shares of XYZ later from BSE or NSE then it is termed as the secondary market.