Valuation of an IPO: How is it done?

While investing in an IPO, one thing that would have definitely crossed your mind must have been about how the valuation of an IPO is accomplished.

Prudent investors understand a company's financials by reading the prospectus and evaluate the company's financials to ascertain if the share-price is priced properly. Also, knowing how an investment bank performs a company's IPO valuation is essential for anybody who wants to become an early investor.

From an economist's point of view, the valuation of an IPO is a game of demand and supply. The higher the demand, the higher the valuation, and vice-versa.

On the other hand, pricing an IPO is a risky affair. If the share price is overpriced, the company is risking under subscription of the IPO, and if the share price is undervalued, then the company is possibly losing the potential fund.

So, let's dive into the topic and understand the valuation of an IPO.

Factors affecting valuation of an IPO

There are particular factors that directly or indirectly influence the price of the share offered and the total valuation of an IPO.

Some of the factors affecting the valuation of an IPO are: 

Growth Prospects - An IPO valuation is determined based on the company's future growth projections. Usually, the main purpose of an IPO is to raise capital to fund further expansion of the business. The fruitful sale of an IPO often depends on the company's forecasts and whether or not they can expand.

The number of shares opened up for bidding in IPO - Depending on the total number of shares owned by the various shareholders in the company, a particular charting is performed. In this charting, the total number of shares opened by these stakeholders, and the ones owned by the company are totaled together.

It is integral to see how much of the company-owned shares are to be opened up for the subscription of the total shares.

The organizational set-up of the company - The complete hierarchy of the company from the executive management, to the chairman, to managing directors, etc. comprises a few key people in any business. Some companies purposely appoint some of the industry key people as part of their hierarchy to pump up their goodwill and credibility, immediately prior to the IPO launch.

Hence, validate the period for which the management has been allied with the company.

Peer comparison - Comparing the business with other listed companies is reasonable. This provides the company considering to file an IPO, a straight & relevant knowledge for the share price estimate.

Effectiveness and Efficiency of the company's business model - Distinct companies run distinct business and revenue models. The underwriting team has to determine if the business model of the company is sustainable for a longer period. Although the team arrives at an answer to this question, several factors are considered. 

The notion of the whole procedure is to check all the parameters at both quantitative and qualitative levels.

Market Trend - This is a broad topic and surely needs a lot of thinking. The business team of the company alongside the employed underwriters are required to evaluate the whole share market trend by examining at a very generic level. 

From this broader outlook, the scrutiny needs to be restricted to the specific industry segment. The general timeline for this trend can be somewhere between the last 12 months to 5 years.

Understanding the market demand - As an element of the whole IPO process, the business and the corporate team of the company do campaign and business meetings with potential investors; which is how the business team gets a practical impression about the demand for their forthcoming IPO.

IPO Valuation Methods

The stock prices of various businesses are valued using different methods such as: 

Absolute valuation

Absolute valuation is done once the company's basic value is assessed against the market value through the company's fundamentals. Through these methods, they arrive at the per-share value.

Relative valuation

Relative valuation functions through matching the company to its industry peers. For this reason, it is also called a comparable valuation.

Discounted cash flow

It is the net current value of the expected cash flows from an investment on any given time. The revenue sources are projected through a series of assumptions about forthcoming performance and then projecting how this business performance converts into the revenue source created by the business.

Economic value

This value is reached mathematically by considering the company's residual income, assets, risk-taking potential, liabilities to be paid off, and other such economic factors.

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

P/E Multiple

One of the most generally used valuation methods is the Price-to-Earnings Ratio. This compares a company's market capitalization to its annual income. To establish the value of the company, its projected equity value is divided by its current net income to realize the price-to-earnings multiple. 

This method is employed once the company has positive cash flows, and when the companies in the same industry have similar growth and capital composition.

Market Value to EBITDA 

This multiple assesses the worth of business procedures which is the enterprise value, rather than the price of the equity. When the enterprise worth is computed, only the operational worth of the business is counted. 

So, it reports for the capital value, and cash and security holdings and investment in treasury bills or stocks of other companies are excluded. When you are assessing the companies which have large liabilities to pay off, they will have negative revenues but a positive EBITDA value.

Why is it essential to value an IPO before investing? 

For valuing an IPO, a company employs an investment bank to underwrite the securities. They are rewarded for building the offer price and making it appear lucrative. They endorse that the price justifies all the applicable inside data of the past functioning and the future payoffs.

The stock price is generally based on the tangible value of the underlying assets. By evaluating the balance sheet information attached in the prospectus, investors can figure out a precise share price to determine whether the market has correctly priced the IPO shares or not.

Closing words

IPO valuation is an important part of IPO selection for any investor. An overvalued share price can be a dangerous bet for the investors, whereas an undervalued share price can often prove to be very fruitful for the investors.

A prudent investor will evaluate the IPO's valuation on their own and then decide on investing.