During a press meet, Securities and Exchange Board of India chairman M Damodaran mentioned that an IPO (initial public offer) grading system has been put in place for the benefit of the average Indian investor. The product may eventually cover rights, as well as follow-on public issues.

The product seeks to analyse fundamentals of the companies to give a sense of direction to the investors, so that they can invest wisely. But the market regulator notes that the IPO grading will not be a determinant of the valuation call on the company. In other words, the IPO grading will not address the pricing issue.

Commenting on the same, managing director and chief executive officer of Crisil, R Ravimohan mentions that IPO grading will answer questions on the fundamentals of the company. According to him, RoE (return on equity) and EPS (earnings per share) will be key factors that will be focussed on while valuing a company.

• FAQs on IPO grading

Anand Tandon of Gryffon Investment Advisors believes that the intent of Sebi is to ensure that the retail investors have a platform by which they can easily judge whether the IPO itself is worth investing in. So, in his view, the objective is laudable.

Excerpts of CNBC-TV18's exclusive interview with Anand Tandon and R Ravimohan:

What could be the loopholes in this IPO grading mechanism?

Tandon: As I see it, the intent of Sebi seems to be to ensure that the retail investors actually have a platform by which they can judge more easily than perhaps the offer documents allow them to judge right now, whether the IPO itself is worth investing in, so the objective is laudable. The question that remains to be asked is that having called it IPO grading, where is the goal post?

Unlike credit ratings for debt instruments, where there is a clear goal post, a company will default or it will not and what is the probability of that and therefore you can grade it on a scale. The question of equity, however, is different because it doesn't have a finite life.

So the first question we need to address ourselves would be - what does IPO grading mean and are we there for making a recommendation or we just looking at ensuring that the compliance that Sebi has set out or for example corporate governance have been met?

So I think Ravi can tell us how they interpret it because I don't see Sebi having specified it out just yet.

What is your response to issues that Anand has raised?

Ravimohan: He has placed the context rightly. I think the whole idea is to first evolve what the right goal posts are. The whole philosophy is, if you look at the equity research there are three components to it - one is the fundamental research, then there is the valuation exercise and third is the investment advice and these three are very critical components.

The equity fundamentals talk about whether the company that you are considering is a good company or not. The valuation addresses the issue whether the price is right and then the investment advises whether this investment is right for a particular investor or not depending on their risk paradigm and time horizon etc.

In IPO grading, we are looking at providing the answer to the question - is this a fundamentally strong company or not, and over time, we hope that we will be able to leave the valuation exercise with enough clues and co-relations between our gradings and also stuff like EPS, EPS growth, return on equity.

This will then give a very good tool for the valuation exercise and the valuers in the market to take the call and price it right, perhaps, even for the investors to have a debate around whether this is a right price for this fundamental strength of the company or not.

I personally think that by dividing the fundamentals from the valuations, we will be able to change the architecture of equity research to the benefit of the investors at large.

How does that work exactly, doesn't that leave more gray area for an investor when you talk about the management quality or corporate governance, which might be great, the brand, which might be great but the price might be completely out of whack?

Ravimohan: I hope that is something, which will evolve faster. The fact is fundamentals is one area which today gets subsumed in the overall equity research including the valuations.

Whereas what I am saying is that once you have a good indications for where the fundamentals are. If the pricing goes out of whack, that is a good indication for investors to stay away from that issue at the IPO grade and hope to pick it up if he thinks the price is too high and is likely to fall after the listing and pick it up in the secondary market.

Who is deciphering that for him because the investment banker isn't, the rating agency isn't, in fact it seems the agency has no liability once it's rated, so does that leave it clear for a retail investor?

Tandon: If the idea is to simplify the investment decision, then you are talking about investors who are not ready to read the fine print or able to understand it. So if you get to a stage where you have a grading from say A to E; 'A' being the best and 'E' being the worst, then it is relatively easy to say that if it means E, then on various hygiene factors, it is not good enough and want to leave it out.

But what does A mean - does A mean that it is a good investment? So my fear is that overtime, it is likely that one will use that as a marketing ploy as well as it will become a simple rule to say, 'it's a great issue, and CRISIL has graded it 'A' and CRISIL is a great company, which means you should buy it'.

This brings us to the point that what happens to the price? Great companies don't necessarily make great stocks and vice-versa.

In fact if it works this way, then what will happen is a company, which is in a transition stage and looking to raise capital for its new business will probably attract an E rating but will therefore command a price, which is so attractive that it will make a great stock.

What about things like new generation businesses, which do not have great earnings records or track records, which people buy on the strength of the prospect like retail companies which probably would be making losses, do not have much by way of return ratios or profitability track records? How do you grade them and do you think rating agencies can therefore have the expertise to look forward into unfolding business with not too much of a historic track record?

Ravimohan: I will come to that in a moment but I think Anand made a great point. Say, Crisil has graded it five but don't you think even for a grade of five, the big pricing that Anand made - if let say, the prices over stretched. I think it's a great way to analyze given one more benchmark and that is exactly the utility that I hope the grading will bring to.

And over time, if you are able to establish some linkages between our grading, our correlation grading and EPS, then it is really the price earnings valuation that the collective wisdom of the market gives that will determine the IPO pricing.

Therefore I think there will greater discipline to the market done, the fear that Anand raised.

As far as the new sectors are concerned, we had a similar paradigm about five years back when mobile telephony was introduced into the market.

At that time, we were asked to grade or rate their credit worthiness and we had fairly challenging first year where we were put to a lot of difficulty not only because it was a new sector and there has been no past history, but also the regulatory situation in the country was evolving.

But I think we handled it well; there were transitions in our ratings, if you take our Bharti Airtel rating, we actually been rating it for the past seven years.

And it's a great story to answer your question that as clarity about this sector emerges, we at Crisil, use macro economic long-term trends and juxtapose it with micro competitive strengths to get a sense of what the long-term prospects are and what's likely to happen between now and then for these various companies.

We are hoping to use a lot of these learnings for new sectors like retail, biotech. This morning, there was a news item about Mumbai University wanting to get listed. So we will figure out good ways of finding fundamental strengths in these businesses.

Do you want comment on that?

Tandon: I have no doubt that any rating agency, with their track record, and with their own experience of various markets, will find ways of rating new companies.

My fear is exactly is that is that the goalpost that we are trying to set for ourselves, is it the job of the rating agency to decide whether or not the business which you should invest in?

As I said you come back to the basic purpose; purpose is to simplify give a one point - yes or no investment decision to the common man (aam aadmi).

Ravimohan: No, that's not the agenda and can't be the agenda because if you take a very simplistic view all I am saying is all of this research that we all put is leading to very simplestly some idea of the EPS and there are two investors with completely different outlook, different confidence levels, different philosophy of life, different liquidity position would come up with completely different PE ratios by with which you multiple the EPS to come to the valuation.

I personally think valuation is dependent on so many factors other than fundamentals, fundamental is one part and where we are getting to with the IPO grading is to get a realistic estimation of where the fundamentals are and then leave it to the market to judge whether the EPS or the valuations that they want to put on that fundamentals to their own judgment. So we cannot go to the end result, which is where we are today which is to say whether to buy or not.

I think it is so customized, that even I will add one more twist to the question that Anand raised that it's a great company but the valuations is stretched and then let say we have a third question that it is a great company valuation is not stretched but I still may not be right investor in that entity because I am a widow and I want to be more concerned about monthly income rather than equity upsides.

So I think we cannot simplify equity investment process to a single point agenda it is a complex issue and I think more we disintegrate into its components - fundamentals, valuations and investment advise I think we are better off and I think we will be able to give better service to the investors at large.