Ever since the grading of initial public offers (IPOs) was made mandatory in 2007, the whole process has been a subject of huge debate. While investment bankers and brokers have stuck to their view that the mechanism is futile, rating agencies have perpetually maintained that higher-graded entities command higher valuations.
In its latest study, Crisil Equities has reiterated that IPOs receiving higher grades from rating agencies continued to enjoy higher price-to-earnings (P/E) multiples. Incidentally, the conclusions of the latest analysis are in line with those of earlier studies done in May 2009, January 2010 and July 2010.
The Securities and Exchange Board of India introduced IPO grading on an optional basis in April 2006. Thereafter, in May 2007, it made it mandatory for all unlisted companies to get their IPOs graded, with the cost for the same to be borne by the issuer company. Rating agencies, including Crisil and Care, grade companies on a scale of 1- 5, with 5 indicating strong fundamentals.
Crisil has analysed 117 listed IPOs, including those listed between May 1, 2007, when IPO grading was made compulsory, and December 31, 2010. The results show that companies with an IPO grade of 5/5 (indicating strong fundamentals) command an average P/E multiple of 18.39, as against 10.13 times for companies with a grade of 1/5 (indicating poor fundamentals).
Companies with IPO grades falling between these extremes (2/5, 3/5 and 4/5) have been trading at average P/E multiples of 10.81 times, 17.82 times and 18.10 times, respectively, according to a statement issued by the rating agency. According to data available on the website of National Stock Exchange, MOIL and Coal India are the only two issues to be assigned IPO grade 5/5 till now.
Tarun Bhatia, director, capital markets, said, “Sustained positive correlation of P/E multiples with IPO grades reaffirms the importance of the fundamental assessment of a company for investors, at the time of investing in its IPO. The market price of a stock can be influenced by factors other than fundamentals, such as liquidity and market sentiments.”
During the period under consideration, 139 IPOs were graded and listed. Of these, 18 companies showed negative earnings per share or P/E multiples of more than 50 times. These were excluded as they were considered outliers. In addition, four companies which did not publish their quarterly results were also excluded from the study.
The methodology involved dividing the closing stock price of the companies (as on March 31, 2011), by the reported diluted earnings per share for the trailing four quarters (March 2010-December 2010), to arrive at a P/E multiple for the company. The average P/E multiples were then arrived at for the companies in each grade. Interestingly, last year, Sebi did an internal analysis to check the efficiency of the grading mechanism and the correlation, if any, with the performance of the shares, post listing. The analysis revealed an absence of any correlation.
“IPO grading is done without taking into account the price at which the security is offered in the IPO. Since it does not consider the issue price, the investor needs to make an independent judgment regarding the price at which to bid for/subscribe to the shares offered through the IPO,” says the IPO grading FAQ section on Sebi website.
While assigning an IPO grade, Crisil Equities takes into account the industry prospects and scalability of the business, along with the earnings potential and the management and corporate governance practices of the company. The grading focuses on the company’s fundamentals and is independent of the issue price.
