How is an IPO valued?

Also known as a public issue, an Initial Public Offering (IPO) is issued when a company wants to raise funds by selling its shares to the public. The company can use the funds raised via the IPO to meet its business expenses.

As an investor, one of the most important aspects of a public issue you need to pay attention to is the IPO valuation. A public issue with an accurate valuation is more likely to enjoy higher demand and perform better than an overvalued issue. This is precisely why companies often dedicate a lot of time and resources to value their IPO correctly. Read on to find out all about IPO valuation and how the share price is determined in an IPO.

What is IPO Valuation?

IPO valuation is an extensive process through which a company determines the price at which its shares are offered to the public for the first time. The issue price is determined by the company in consultation with the Book Running Lead Manager (BRLM) of the IPO.

Since the success of the issue hinges primarily on arriving at a valuation that strikes a balance between investor demand and maximizing the funds raised by the company, companies often view valuation as a critical step in the Initial Public Offering process.

Understanding the Valuation Process of an IPO

Knowing how a company arrives at its IPO value is crucial if you plan to invest in a public issue. This will help you assess the offer more accurately and encourage you to make a well-informed investment decision.

The IPO valuation process involves accounting for a plethora of different methods and factors. Let’s look at some of these key factors that help a company determine the price of its IPO.

• Absolute Factors

  Absolute factors are those that provide insights into the company’s financial performance and fundamentals. Revenue, cash flows, assets, liabilities, profitability, future growth potential and economic value are a few examples of absolute factors. The Book Running Lead Manager, along with the issuing entity, examines past financial statements and future earnings and growth potential comprehensively to determine the IPO valuation.

• Relative Factors

  Relative factors are those that enable investors to draw comparisons between the company offering the IPO and other similar entities. Price-to-Earnings (P/E) ratio, Debt-to-Equity Ratio, Price-to-Earnings-to-Growth (PEG) ratio and Return-on-Equity (ROE) are some of the key examples of relative factors. Companies offering public issues often do extensive comparative analysis with their rivals and industry peers to arrive at the IPO value.

• Discounted Cash Flow Analysis (DCF)

  Discounted Cash Flow Analysis or DCF is a method that companies regularly use to determine the present value of their predicted future cash flows using the time value of money. The discounted cash flows arrived through this method are factored into the calculation of IPO value along with the company’s present cash flows.
  That said, the DCF method is not without its flaws. The projected future cash flows that the method uses may not materialize, which can skew the result significantly. Therefore, as an investor, you need to account for such situations when analyzing a company’s IPO valuation.

• Industry Dynamics

  Industry dynamics is another very important factor that the IPO issuing entity and the BRLM consider when arriving at the price of the public issue. A company operating in a complex industry with high barriers to entry is likely to command high valuations.
  Comparatively, a company operating in an industry with little to no entry barriers is likely to be valued lower. In addition to this, companies also consider other connected factors like the number of competitors, market share and regulatory involvement when ascertaining industry dynamics.

• Market Sentiment

  Market sentiment is often one of the most influential factors that determine an IPO’s valuation. It can be defined as the collective attitude of investors in the market and can either be optimistic, pessimistic or neutral. Market sentiment is influenced by a range of different factors like economic data, earnings reports, geopolitical events and central bank policies, among others.
  When the market sentiment is optimistic, companies often tend to set a high IPO valuation since investors would be more likely to invest regardless of high valuations. On the other hand, when the market sentiment is pessimistic, companies either set a low IPO value or cancel their plans to go public entirely since investors would generally want to remain on the sidelines.

Conclusion

With this, you must now have a good understanding of how share price is determined in an IPO. Companies offering their shares to the public for the first time usually tend to be cautious while determining their value.

Overvalued public issues often don’t perform well and undergo significant market correction when the shares are finally listed on the market. Meanwhile, the chances of share prices rising after listing are high with undervalued and appropriately valued public issues. Therefore, if you’re interested in investing in an IPO, remember to take the time to evaluate the share price to determine whether it is appropriate or not.