How is an IPO Valued?

Introduction

IPO or Initial Public Offering is the process of listing a company in one or more stock exchanges. After the listing, the company’s ownership gets diluted. During the IPO application process, the company’s owner decides how many shares they want to offload through the IPO. It then appoints a merchant banker who goes through its financial report card, business prospects, predominant risks, and management style to determine the IPO price.   

The price of an IPO is usually determined in two broad ways - book building offering and fixed price offering. In book building offering, the merchant banker sets a price range, also known as the price band. The price band has the floor price on one side and the cap price on the other. Hence, a book building IPO price may look like 100 - 110. Investors may select the number of lots they wish to apply for and the price at the time of application. The price is fixed in a fixed price offering, and investors have to pay the full amount upfront. 

While the process of IPO valuation might seem easy, it is not. An overpriced IPO might not get enough takers, and the company may lose a considerable amount and credibility. In contrast, an underpriced IPO might not attract NIIs and QIIs or make investors sceptical. Hence, maintaining equilibrium is crucial while determining the price of an IPO.

What Does IPO Valuation Mean For an Investor?

As an investor, you must know the IPO valuation process for two reasons:

1. It gives you a clear idea of the company’s business prospects and future growth opportunities. 

2. You can seamlessly sift through overarching advertisements to get a clear picture of the company by analysing the financial, income, and cash flow statements.

What Are The Components of IPO Valuation?

The principles of supply and demand govern an IPO launch - the higher the demand for the company’s shares, the more the price will be. Besides the demand, other factors like industry comparables, growth opportunities, and the company’s corporate-story play equally important roles in determining the IPO price. 

Here is a laydown of each component:

Demand

Demand refers to how big investors consider an IPO to be. In early November 2021, Paytm launched the biggest IPO of all time. With an issue size of INR 18,300 crore or US$ 2.47 billion, the IPO was priced at INR 2,150. The issue was subscribed 1.89 times. However, the company was listed at INR 1,950, at a 9.3% discount to its IPO price. This shows that demand is rarely an accurate indicator of the company’s valuation. But, investors often look at the demand before investing in an IPO. 

Industry Comparables

If the company launching an IPO has many competitors already listed on the bourses, investors will compare the company’s valuations with the listed ones. If they consider the IPO as overvalued and too different from their competitors, they might not invest in the IPO. 

Growth Potential

A company’s growth potential also plays a crucial role in determining the IPO price. Companies generally raise money from the market to fund their business ambitions and fuel their growth. However, if a company’s primary purpose for going public is to consolidate its debt, the valuations might be quite low. Investors prefer investing in a company with a solid growth story. And, companies that display their growth vividly might arouse higher investor interest.  

The Industry Narrative

Sometimes, the industry narrative may influence the IPO price more than quantitative figures. For instance, the COVID-19 pandemic brought the pharmaceutical industry back in focus. This can automatically increase the valuation of a pharma company launching its IPO. 

What are the Methods of IPO Valuation?

IPO valuation is a complicated activity undertaken by trained merchant bankers and financial experts. The step is crucial because the Securities and Exchange Board of India (SEBI) evaluates every detail before giving a green signal. 

Here are the top valuation methods adopted by merchant bankers to set the IPO price:

Relative Valuation 

In this method, the merchant banker looks at the already listed companies’ valuations and decides the best price. Here, factors like price to earnings ratio, cash flow, and earnings per share get prominence.  

Absolute Valuation

In this system, the merchant banker takes the Discounted Cash Flow (DCF) route to assess the company’s financial condition and measure its strengths. Unlike relative valuation, absolute valuation factors in the company’s actual wealth and interest determine the price. 

Discounted Cash-Based Valuation

Here, many financial experts join hands to evaluate the company’s expected cash flows, potential revenue sources, future performance potential, etc. This method is more challenging than the relative or absolute valuation method since an incorrect estimate may increase or decrease the company’s valuation. 

Economic Valuation 

In the Economic valuation method, the merchant banker considers various parameters like business residual income, debt status, the net value of assets owned, and many more.

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