Chapter 7: How is an IPO valued?

• Evaluation process of IPOs
• Factors that decide IPO valuations
• How to decide if the IPO is worth investing in

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. Beneath the glitz are numerous brainstorming sessions of  dedicated, hard-nosed teams of number-crunchers who are out to divine one truth — the right IPO valuation.

The perfect alchemy 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.

Quantitative and qualitative components

These are two further factors that decide IPO valuations. Let’s look at them in detail:

• Quantitative components

  A successful IPO depends on the demand of the company, its products and services and the hype generated.

  A strong demand for the company will lead to a higher stock price. A company might have different valuations, merely because of the timing of the IPO as compared to market demand. For instance, the demand and hence, value of mangoes are higher in the summer as compared to other seasons.

  Another aspect is industry comparables. If the IPO candidate is in a field that already has comparable publicly-traded companies, the IPO valuation may be linked to valuation of its direct competitors. 

• Qualitative components

  The IPO valuation is not based on numbers and financials alone. There are other factors at play too.

  If a company is on the verge of a breakthrough, that can have a major role in deciding the company’s valuation.

  In the past, companies that promoted new and exciting technologies were given multi-billion-dollar valuations, despite have little or no revenues.

  Another aspect which can boost valuations is having well-known industry experts and consultants under your belt. Hiring them gives confidence and credibility to the company’s story.

  The investment bank has done its job. But how do you know it’s a fair valuation? The decision is not that easy.

  Here are a few points you need to consider before investing in an IPO:

• Self-assessment

  Here are a few questions you need to ask yourself:

• Would you be comfortable to own the stock even if the stock fell by 50% tomorrow?
• How much percentage of your portfolio are you planning to invest and what is your risk tolerance?
• Are you planning to invest in order to “flip” (short-term profit) it or are you investing for the long run? Based on this answer, you’d understand what nature of IPOs are more suited to you.
• Strong fundamentals

  No matter what your strategy is, considering certain factors is imperative before making a decision.

  • DRHP – Your Bible

    Every company is required to file a draft red herring prospectus (DRHP) with the Securities and Exchange Board of India (SEBI). Browsing through this document would give you insights into the financials and other information about the company. Usually, if the higher percentage of shares are held by institutional investors and banks, it is a positive sign.

  • Strong Promoters

    Recognised names bring a certain credibility to the table and consequently, add a premium to the price.

  • Grading

    The grading of an IPO is also an important indicator. Generally, higher grading is a positive indicator. Having said that, it is not an absolute indicator. Certain companies with excellent grades have withdrawn their IPOs in the past whereas certain medium-graded companies have performed excellently.

  • Objective

    Where will the funds be used? What is the objective of the IPO? The answers to such questions could help judge the time frame of returns. The objective will also suggest the company’s future growth prospects.

  • Do you understand the business?

    As a general rule, it is advised not to invest in something you cannot understand.

• Risks

  Whenever you decide to invest in a company, there is a certain amount of risk involved. But one could term it as a “calculated risk” based on the past performance of the company, the sector trend and other factors and analysis.

  When you decide to invest in an IPO, it is like taking a leap of faith, because of two primary factors: Do you know enough about the company? And, has the market had enough time to react and justify the buying price? These two questions pose a greater risk in IPO investing.

  • What if the offer price is wrong and the market price is right?

    This would indicate that the company is coming into the market at a relatively higher price. This might reflect the over optimism of the management.

  • What if the offer price is right and the first day price is wrong?

    In this case, the low first day returns indicates market inefficiency in the short-term. This could lead to a downgrade of the stock and could affect the price in the long run.

  • Absolute risk

    This risk comes into effect if the company goes out of business.

  • The honeymoon phase ends

    IPOs attract big attention on day one but things can turn for the worse from thereon. Data shows that from 1970 to 2012, a typical IPO gained just 0.7% in its second six months.

• Pitfalls
  
  • Rumours and success stories

    While success stories and rumours present a very favourable case for a company, they should not be trusted. Always go by facts and figures rather than blindly believing on recommendations.

  • Investing in brand promoters

    A strong brand does help an IPO to create hype but they are no guarantors for its future performance. Check the financials and verify if the numbers attest the image.

  • Investing without an exit strategy (no stop loss)

    This is a general rule and also applies to IPOs. Do not marry the stock if you realise you are in the wrong IPO. Be prepared to cut your losses short and do not get emotionally attached just because you are invested.

    Investing in an IPO has its risks so make sure you understand the prospectus properly before drawing any inferences.

A quick recap

The savants at investment banks use various methodologies to come up with the right IPO valuation. However, it is up to you to do your research before buying them. Don’t invest on mere hearsay and recommendations. Always study the financials of the company before investing in an IPO.

What next?

While we have spoken about IPOs as one monolithic event so far, there are different versions to it. Let’s look at them in the next chapter.