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How is an IPO valued?

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How is an IPO valued?

The price of an IPO is decided by the supply and demand of the trade market. Usually, they are sold at the price at which the buyer would like to buy. If an IPO is underpriced, then a chance of pocketing the gains after the listing is for a long period. On the other hand, if it is overpriced, post listing you won’t get much gain. 

The stock prices of different businesses are valuated using different techniques such as:

Factors which influence the pre-IPO valuation

Absolute valuation

Relative valuation

Factors which influence the pre-IPO valuation

The company and its underwriters work together to come up with a share price. Factors which influence pricing are,

The quantity of stocks being sold in an IPO

The organizational set-up of the private company

The current prices of the stocks of similar companies in the same sector

Company’s growth potential

Company’s business model financial effectiveness

General overall market trend

The demand from the potential customers for company’s stock

Sometimes, the company’s success story, the values they believe in, products they offer may also affect pricing.

Absolute valuation

Absolute valuation is when the company’s basic value is estimated against the market value using the company’s fundamentals. By using these techniques they arrive at per share value.

Discounted cash flow:

It is the net current value of the anticipated cash flows from an investment as at today or on any given time. The revenue streams are projected by using a series of assumptions about how the future business performance and then forecasting how this business performance translates into the revenue stream generated by the business.

Economic value:

The value is arrived mathematically by considering the Company’s residual income, assets, the risk bearing potential, debts to be paid off and such economic factors.

Value of equity = Enterprise value + Value of cash and investments - Value of debt and other liabilities

Relative valuation

Relative valuation works by comparing the company in question to similar companies in the same business. That is why it is also called comparable valuation.

Price to Earning Multiple:

One of the most common valuation method used is Price-to-Earning multiples. This compares a company’s market cap to its annual income. To determine the value of the company, its estimated equity value is divided by its recent net income to find out the price-to-earnings multiple. This method is used when the company has positive cash flows and when the companies in the same sector have similar growth and capital structure.

Value to EBITDA multiple:

This multiple, measures the value of business operations which is the enterprise value, instead of the value of the equity. When the enterprise value is calculated, only the operational value of the business is considered. So, it accounts for the capital value and cash and security holdings. The investment in treasury bills or bonds, or investment in stocks of other companies, is excluded. When you are evaluating the companies which have huge debts to pay off, they will have negative earnings but a positive EBITDA value. 

Why is it important for an investor to know how IPO is valued?

To value an IPO, a business hires an investment bank to underwrite the securities. They are paid to make the offer price look lucrative. They certify that the price accounts every relevant inside information of the past performance and the future payoffs.

Stock share value is usually based on the tangible value of the underlying assets. By using the balance-sheet information enclosed in the prospectus, potential investors can compute an accurate share value to help establish whether the market has correctly priced the IPO shares.

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