How Is An IPO Valued?
IPOs generally send a thrill in the market. It garners public attention, throws the media into a frenzy and gets investors lapping up every information. But the behind-the-scenes are a lot different. The perfect alchemy of valuing an IPO is very hard to achieve. The whole pricing method revolves around the basic economic forces of demand and supply, but getting the right share price is a difficult task. Sometimes, you need to unlock a combination of multiple methodologies to get it right.
But broadly speaking, there are two pricing methods that are generally used by investment banks — the people tasked with hitting the sweet spot. They are:
- Absolute valuation
- Relative valuation
Absolute Valuation
Here, the company’s value is determined by analyzing a company’s fundamentals.
This technique uses discounted cash flow (DCF) analysis to determine a company’s financial health.
Under the DCF model, the future cash flows are projected by using a series of assumptions about the future business performance. It is then discounted.
After the discount, the present value that is finally calculated is regarded as the true worth or intrinsic value of the firm.
Under the broad umbrella of the discounted cash flow (DCF) model, there are multiple analysis carried out. Some examples of these analysis are dividend discount analysis, discounted asset analysis and discounted free cash flow analysis.
There is another methodology known as the economic value. Here, the value is arrived by taking into account a company’s residual income, assets, debts, potential and other economic factors.
However, there are challenges associated with the DCF analysis.
Forecasting cash flows with certainty and projecting how long the CFs will remain on a growth trajectory is difficult.
In addition, evaluating an appropriate discount rate to calculate the present value can be complicated.
Due to the above challenges, a combination of analysis is used to minimize the error factor and to get as close to the accurate valuation, as possible.
Relative Valuation
Under this method, a company’s share value is determined by taking into account the value of similar companies.
This is in contrast with absolute value, which looks only at a company's intrinsic value and does not compare it with other companies.
Under such analysis, relative value methodologies come into play. Calculations that are used to measure the relative value of companies include the enterprise value (EV) ratio, price-to-earnings (PE) ratio, or price/EBIT.
In order to compare values, the first step is to identify and segregate comparable corporations. This crucial step could be carried out by looking at market capitalization, revenue, or sales.
After this, price multiples are derived. This could include ratios such as price-to-earnings (PE) ratio and price-to-sales ratio. In the PE multiple, the company’s market capitalization is compared to its annual income.
In the price/EBIT, the value of business operations, which is the enterprise value, is measured. In this case, only the operational value is considered. Usually companies which have extensive debts, have negative earnings but a positive EBIT.
While relative valuation incorporates many multiples, it is important to use absolute valuations too. Using these methods, analysts arrive at a present value estimate.
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