How to Read a DRHP:
For Pre-IPO Investors in Unlisted Shares
By Kanishk Devbangia, NISM Series XV Certified Research Analyst (NISM-202300182946)
1: What Is a DRHP — and Why Should Unlisted Investors Care?
Draft Red Herring Prospectus is a preparatory document prepared by the company filing it with the Security Exchange Board of India (SEBI), whenever the company proposes an issuance of capital through the public offer. 'Draft' implies that it is the initial version of RHP which requires further clarification or disclosure from the company; later, the company will file the Red Herring Prospectus (RHP) as per the requirements of SEBI.
While for most small investors, the DRHP would be relevant only during the process of IPO applications, the case for investors dealing with the unlisted shares is totally different. Investors who have unlisted stocks may be holding such shares because of the reasons stated by the company during its unlisted trading phase. The DRHP is the very document wherein the company makes disclosures that would help you determine whether the company was telling the truth about its business proposition to the investor.
2: Objects of the Issue — What Is the Company Doing with the Money?
Fresh Issue vs. Offer for Sale (OFS)
A DRHP would clearly state whether an IPO consists of a Fresh Issue of shares, an OFS, or a combination of the two. It is important for share investors who do not have shares listed to distinguish between them.
The term "Fresh Issue" refers to the creation of fresh shares by the company with the proceeds going directly to the company for purposes such as capital expenditure, debt redemption, working capital, or acquisition. This is normally seen as a good indicator since the company is investing in growth.
In an OFS, it refers to the sale of the existing shares by the shareholders of the company, which could be the promoters, earlier shareholders, or employees. In an OFS, the proceeds go to the selling shareholders, not the company. A high OFS ratio might indicate that the promoters are exiting from their shares, which could raise eyebrows.
3: Business Overview & Industry Analysis — Does the Story Hold Up?
The business overview section usually constitutes the longest and the most narrative part of a DRHP. It tells the story of the firm, including its line of business, how it derives profits from its business, its customers, and its sector. Take the section to be a pitch by the company for investment in itself – written by investment bankers and lawyers, of course.
What to Look For
This section will also feature the business model of the company, along with some other details like their key products/services, geographical footprint, competitive positioning, etc. From an investor perspective, this information can be used to verify whether the company was pitching something different from what they have actually been doing in the unlisted share market.
It is important to note the competitive moat that the company uses to create value. What is it – pricing power? Strong brand recognition? Technological leadership? Regulatory licences? Any competitive moat that is clearly visible and sustainable can be considered an indicator of long-term investment potential in the company.
4: Financial Statements — The Numbers That Actually Matter
This is the most important section of the DRHP. The financial statements are audited and represent the most reliable data available on the company's performance. The DRHP must include at least three years of audited financials, restated to comply with Indian Accounting Standards (Ind AS).
Revenue Growth and Quality
First off, take a look at the top-line figure. Are revenues rising for the firm steadily? What kind of growth rates have been achieved? Most important, however, is the quality of revenue growth. The numbers may be inflated by one-off contract signings, government grants, or reclassifications of accounts. True revenue growth should be organic.
Profitability and Margins
Evaluate the EBITDA margin and the net profit margin in the three years under analysis. Are the margins steady, rising, or declining? A firm that experiences a fast-growing income level but declines in the margins is likely to be experiencing growth at the expense of profitability – a typical trend in firms in hyper-growth sectors like technology and consumer goods. It depends on the industry and whether management's strategy for achieving sustained profitability is realistic.
Analysis of Cash Flow
Most private equity investors concentrate on the profit and loss account when evaluating the financial performance of firms, but the cash flow statement usually reflects more accurately what is happening in a firm. A business can register positive net incomes on its books while running out of money at the same time owing to cash management problems or capitalizing on expenses.
5: Risk Factors — Reading What the Company Is Warning You About
Do not just list out the risks. Each DRHP would contain around 30 to 60 risk factors. Some of these would be fairly common such as "any change in government policies could adversely affect our business" or "the business faces competition from other established companies". While these are valid risks, they apply to any business venture.
You should pay attention to the risks faced by this particular company. Legal disputes with an important client or regulatory authority, any large claims from regulators against the company, lack of certain regulatory approvals, dependence on a single source for supply of goods/materials or technological risks associated with untested product ranges are some of the key areas to look into.
Risks Specific to Unlisted Share Investors
The risk that would pertain particularly to your case would not be covered under any risk factor disclosed in the DRHP. This would be the difference between your purchase price of the unlisted stock and its eventual listing price. Whether the purchase price is higher than, lower than, or at par with the range of the IPO price, you can calculate valuation multiples through the financials of the DRHP.
6: Valuations — Linking the DRHP to Your Pre-IPO Investment Decision
An IPO price is not specified in the DRHP, but rather revealed later on in the prospectus. Nonetheless, the DRHP will provide you with all the relevant figures required to perform the necessary calculations yourself, to see if the value assigned to the company makes sense.
Taking the financial figures provided in the DRHP, compute the past-twelve-months revenues, EBITDA, and net profit of the company. You should then compare these figures against the value at which you bought your own unlisted stocks. Should you have overvalued the stock and been willing to pay too much for your stock, the correction is likely to take place during listing.
Common valuation ratios employed in pre-IPO valuation include P/E ratio, EV/EBITDA, and sometimes Price/Sales if it comes to an early-stage unprofitable business. Different industries apply different valuation ratios; for example, while a fintech business valued at 10 times its revenues looks normal, it would be highly overvalued if it were a manufacturing firm trading at 15 times earnings.
7. Conclusion:
To most individual investors, the DRHP is a paper that they quickly go through before completing their IPO application form. For those holding unlisted stocks, the DRHP is a priceless source of analysis that comes well ahead of the IPO – allowing you enough time to think and act wisely on your holdings.
A thorough study of a DRHP will not take you more than two or three hours once you get acquainted with its format. The chapters that should hold your attention are the objectives of the issue, the financial statements, risk factors, and promoter profile. All of these four chapters combined will provide you with an accurate understanding of the company, free from any of the gossip that is usually circulated in the unlisted share market.
In the unlisted stock market, those who have done their homework well reap the benefits.
Disclaimer:
This is written for educational and informational purposes only. Nothing here constitutes investment advice or a recommendation to buy or sell securities. All data is sourced from publicly available information. Investments in securities markets are subject to market risks — please read all offer documents carefully before investing.
