How Is An IPO (Initial Public Offering) Priced?
An Initial Public Offering (IPO) is the process by which a company issues shares to the public for the first time. Considering going public is a long-term strategy, companies need to closely evaluate its systems and controls, accounting standards, governance models,etc. During this process, several investment banks work together to decide on the issuing company’s valuation and share prices.
Firms hire professional financial experts to conduct this comprehensive evaluation. Investors and traders must necessarily know about pricing processes that determine the IPO share prices of a company.
This blog will take you through techniques that financial experts use to determine IPO share prices. Keep reading to know how to make an informed decision.
What Is an IPO?
Initial Public Offering (IPO), is the process using which a private company “goes public” for the first time. By doing so, it allows retail investors to buy and invest in shares of the company. Any company, from a start-up to an old establishment can announce an IPO and invite investors to purchase their shares.
There can be many reasons for a company to launch its IPO including raising capital from the general public, getting more visibility and adding to the liquidity of its shares. This can only happen when the company lists its shares in the primary market. By purchasing shares from such companies, investors hold partial ownership here. Consequently, investors can earn from the shares as they become more valuable with the growing business of the company.
How Is the Pricing of an IPO Done?
After the company applies for an IPO, its management decides on the number of shares that will be listed in the primary market. Following this, they appoint investment bankers to analyse their finances, plans, potential risks, and many other factors to determine the prices of these IPO shares.
They follow some specific methods to determine the IPO prices. These are:
- Economic Valuation
In this procedure, investment bankers consider several economic factors to determine IPO pricing. Factors such as Net value of the company’s assets, outstanding borrowings, risk-bearing capacity, and residual income of the firm are considered to calculate the IPO’s price.
- Discounted Cash flow Valuation
Discounted Cash Flow (DCF) valuation is a method used to estimate the intrinsic value of a company, or a project, by forecasting its future cash flows and then discounting them back to their present value. The basic idea behind DCF is that the value of an investment today is equal to the sum of its future cash flows, discounted at an appropriate rate to reflect the time value of money and the level of risk associated with the investment.
The process of DCF valuation typically involves three steps: forecasting future cash flows, selecting an appropriate discount rate, and performing the calculations.
- Forecasting Future Cash Flows: The first step in DCF valuation is to forecast the future cash flows of the company. This typically includes forecasting the company’s revenue, expenses, and capital expenditures for a period of time, usually five to ten years.
- Selecting an Appropriate Discount Rate: The second step is to select an appropriate discount rate. The discount rate is the rate at which future cash flows are discounted back to their present value. It is determined by the cost of capital, which is the rate of return required by investors to compensate them for the level of risk associated with the investment.
- Performing the Calculations: The final step is to perform the calculations. This involves taking the forecasted cash flows, discounting them back to their present value using the selected discount rate, and summing them up to arrive at the intrinsic value of the company.
DCF is the most common method of determining the price of an IPO.
- Absolute Valuation
This valuation approach determines the intrinsic value of the company. The absolute valuation technique uses a firm’s financial strength, growth prospects and risk profile to determine its share price. The value of the company’s plants and other assets are determined, and based on that total valuation of the company is decided. The debt of the company is also considered in this method to come up with a reasonable valuation.
- Relative Valuation
As the name suggests, the relative valuation method provides a comparative analysis. By using this method, experts compare the value of similar listed firms to come up with the value of the company. Investment Bankers consider parameters like cash flow, earnings per share (EPS), and Price-to-Earnings (PE) ratio to determine the share price of an IPO.
What Factors Influence IPO Pricing?
The following factors play a pivotal role in determining IPO prices:
- Potential Growth of the Company
A company’s prospect for growth plays a major role in determining its IPO price. As we know the primary goal of a company going public is to fund its business goals and repay its debts. Investors tend to prefer investing in companies with stronger growth prospects. This ensures higher returns for them in the long run.
Investors tend to compare the IPO prices of a firm against the listed share prices of its competitors. By comparing the IPO’s prices against the current market prices of its competitors, investors can assess if the company is overvalued or undervalued. If they notice the IPO prices vary considerably from other firms, investors might choose not to invest in such shares.
- Economy and Industry Narrative
Sometimes the industrial and economic scenario affects the IPO pricing. For instance, the COVID-19 period brought the pharmaceutical industry to the limelight. In case of an economic slowdown, investors may prefer to invest in low-risk assets. In this way, the state of the country’s economy and the particular sector affects the IPO share prices.
- Past financial performance of the company:
Past financial performance of a company is used to determine its initial public offering (IPO) pricing by providing an indication of the company’s financial health and growth potential. This information is used by underwriters, investment banks, and other financial professionals to set the initial price of the stock when it is first offered to the public. Factors that are typically considered include revenue growth, profit margins, and earnings per share. Additionally, the company’s industry, competition, and management team are also evaluated when determining the IPO pricing. Ultimately, the goal is to set the initial price at a level that will attract investors while also providing an appropriate return for the company and its early investors.
Private companies go public after gaining a certain degree of vintage and reputation. This is because higher demand for the company’s shares heavily influences the price of the IPO shares. Demand here refers to how big or important investors consider an IPO to be.
Other factors that tend to influence the prices of IPO shares are as follows:
- Share market trends
- Number of stocks that a company is planning to sell in an IPO
- Business model of the company
In conclusion, the pricing of an initial public offering (IPO) is a complex process that involves multiple factors, including the company’s past financial performance, its industry and competition, and the current market conditions. The process is typically led by underwriters and investment banks, who work together to set the initial price of the stock at a level that will attract investors while also providing an appropriate return for the company and its early investors. It’s important for investors to be aware of the various factors that go into determining the IPO pricing and to conduct thorough due diligence before making any investment decisions. Overall, it can be a great opportunity for both the company and investors, but it requires a lot of analysis and decision making before the stock is offered to the public.
Frequently Asked Questions
Why do companies announce an IPO?
Companies announce IPO to fulfil objectives like business expansion, repayment of the debt, and funding working capital, establishing the company’s credibility in capital markets.
How to know whether an IPO will do well or not?
You can only make an informed guess on whether a company will perform well after its listing. To do this, you must conduct sufficient research. It will involve a study of the company’s past performances, future projections, and comparison with its rivals and peers in the same industry. Furthermore, you must gain a comprehensive understanding about the firm’s business model.
What role does SEBI play in an IPO?
The SEBI thoroughly studies each IPO application to determine the authenticity of these applicant firms. By doing so, SEBI ensures that the amount that investors are providing in the IPO is going to credible destinations.
When can a company go for an IPO?
The company must have been in business for at least 3 years. Furthermore, the company should have at least Rs 3 crore in net tangible assets in each of the previous three years. Also, the companies must have a minimum net worth of ₹1 crore in the previous three years. On top of that, any three of the five previous years’ operating profits should have been at least 15 crore rupees (pre-tax).