How Are Initial Public Offerings (IPOs) Priced or Valued?
Initial public offerings (IPOs) have become one of the most popular methods of raising funds by private companies in India and abroad. Each IPO launch comes with a price band which many people also refer to as the IPO price. There are various factors that go into deciding this price range.
It is important to get the pricing of IPOs correct. This is because an overpriced or underpriced issue may lead to less interest among investors and defeat the purpose of launching the IPO. Let’s discuss the intricacies of IPO pricing or valuation.
What Factors Determine IPO Valuation?
Here are some factors that merchant bankers or investment bankers consider before deciding on IPO valuation:
- Number of shares up for sale in the total IPO process.
- Organisational hierarchy of company issuing initial public offering and the promoter’s background.
- Peer analysis i.e., looking at the trading price of competitors and companies from related industries.
- The growth outlook or potential of the company in short-term and medium-term timeframes and its financial robustness and standing.
- Financial robustness and standing of the company.
- The overall market trend which includes investor sentiments, macroeconomic conditions, etc.
- Demand or interest shown by prospective buyers.
- Growth story, products offered and industry in which the company has been functioning.
What Are the Two Types of IPO Valuations?
Here are the two valuation approaches that investment banks take into consideration to compute IPO prices:
- Absolute Valuation
In this method, merchant bankers and underwriters closely analyse A company’s fundamentals. They do so to know the actual or intrinsic value of the company with regard to its overall market value. Underwriters can arrive at absolute valuation by using discounted cash flow or by calculating the economic value of the company .
Discounted cash flow is the net present value of expected cash flows from any investment made as of today or a future date. There are several assumptions that analysts consider to evaluate the discounted cash flow.
The economic value is computed by using a proper mathematical formula. This formula considers the company’s residual income, risk-bearing potential, assets and debts that it needs to pay off. The mathematical formula is as follows:
Equity value = (Cash and investment value + Enterprise Value) – Value of debt and any other liability that the company has
- Relative Valuation
As the name suggests, this method entails comparing the company with its competitor companies on different parameters, such as price-to-earnings ratio, EBIDTA, etc.
Firstly, the most common indicator this method uses is the price-to-earnings multiple. This indicator creates a comparable analysis of the company‘s market capitalisation with its annual income. For the computation of the company’s value, analysts divide the value of the company’s equity with its recent net income to get the price-to-earnings value.
Another parameter used in the computation of IPO value is Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA). The main aim of this multiple is to get an idea of the company’s enterprise value instead of equity valuation. When dealing with business value, only the operational value of the company is considered.
Investments made in various treasury bills, bonds, and equity of other companies do not form a part of the calculation. Companies having huge debts will have negative earnings but EBITDA value shall be positive.
In recent times there has been a spurt in the number of IPO launches in India with more people taking a keen interest in stock markets to make money. Companies want to tap this demand and raise money for their operation. IPO pricing is a complex process which involves the use of a number of indicators and rigorous market analysis. As an investor, you should assess all aspects of an IPO launch before investing in the same.
Frequently Asked Questions
What does IPO valuation mean for investors?
As an investor, you must have the requisite knowledge about the valuation of IPOs. This is because it will give you clarity regarding the business’s future goals and prospects. Moreover, you will be in a better position to know whether you should invest in the same.
What are the components involved in IPO valuation?
There are various components involved in the pricing of an IPO. It includes a comparison of the company with its competitors in the industry, the growth outlook of the company and the demand for its stock in the market.
Who regulates the IPO process in India?
The Securities and Exchange Board of India (SEBI), which is India’s apex capital markets regulator, monitors the entire IPO process of companies. It examines IPO applications and papers to ensure the safeguarding of investors’ interests.
What is the difference between absolute and relative valuation?
The main aim of absolute valuation is to analyse a company’s wealth by taking into account the time value of money. On the other hand, the relative valuation method compares a company’s wealth with the wealth generated by its competitors.