An in-depth Guide on IPO Valuation

Image Caption: A complete guide to IPO valuation

The price of shares of an IPO is largely determined by supply and demand, which in turn, is decided by the issuing company’s growth and profitability prospects. Investors must be aware of how much a company is valued based on its future prospects to choose a profitable investment. 

These facts can be established by thoroughly analysing the financial statements of a corporation. Before issuing an IPO, companies are mandated as per SEBI guidelines to disclose such information in the IPO prospectus. To know how to analyse its information and determine if an IPO is worth its price, read through the following sections.

However, before we start, let’s revise the basics of IPO and its working.

What Are IPOs and How Do They Work?

Initial Public Offering or IPO is a process through which privately owned companies list their shares to the public for the first time. Post-IPO, the companies are no longer private and are partly owned by retail/HNI/Institutional shareholders, who purchased a part of the company’s ownership via its shares.

Companies issue IPOs on the primary market to investors, to raise funds for expansion, research and other corporate purposes. They must fulfil various eligibility criteria and file an IPO prospectus with the market regulator to be able to issue an IPO. After approval, they decide on the price of shares and the issue date.

Investors place bids on these shares and if allotted, get them credited to their Demat accounts. Next, these shares are listed in the secondary market, where investors can sell them to other investors to make profits.

This process involves complicated mathematical calculations considering the diverse financial aspects like business prospects, management style, stats, and risks involved.

How Are IPO Priced?

Two major processes determining IPO pricing are as follows:

• Book Building Offering

In this process, the investment bank or the merchant banker assigns a price band for a company’s share, based on market trends and the number of shares allocated. The price bands have a floor and cap value which signifies the minimum and maximum price of stock beyond which, bids cannot be placed.

For example, if the price band of a company’s share is ₹100 to ₹120, investors will only be allowed to bid within these assigned price ranges. Thereafter, the underwriters or the book-building managers analyse the minimum bid for which the company is able to allocate all its shares. Therefore, the decided price within the price band acts as the cut-off price of the share.

• Fixed Price Offering

Fixed price offerings have fixed share prices and the investors have to pay their full price upfront. Therefore, demand for shares can only be determined after the end of the issue session. Furthermore, half of the shares allocated are reserved for bid applications below ₹2 lakh, whereas the remaining half is reserved for higher bid applications.

How Are IPOs Valued in the Share Market?

Evaluating an IPO requires intensive calculations, and a prolific market understanding to ensure that the funds invested by the general public for purchasing shares are worth the price. Therefore, the Security Exchange Board of India (SEBI) carefully profiles the participating companies by analysing each IPO application.

The various methods defining IPO valuation are as follows:

• Relative Valuation

Relative valuation utilises a company’s financial data in the form of ratios, to compare with companies in similar industries and asset classes. These ratios help to assess if stocks are overvalued or undervalued.

• Absolute Valuation

The absolute valuation method does not compare a company’s performance with its peers. Rather, it relies on a company’s financial statement including cash flow, dividend reimbursement, growth prospects, etc.

• Economic valuation

In the economic valuation method, underwriters or merchant bankers consider an entirely mathematical way of evaluating an IPO share, based on business residual income, liabilities or debt, assets owned, risk-bearing potential, etc.

• Discounted Cash Flow Based valuation

In this method of IPO valuation, the present value of projected future cash flows is calculated. The process is considered more challenging compared to the previous mode of valuations as it requires absolutely precise calculations. Even a small change in assumption might affect the company’s financial forecast and valuation drastically.

How to Analyse an IPO?

Since the companies offering IPO do not have any historic data available to support their market stature. Let’s consider some of the parameters through which you can profile companies and make an effective decision towards investment.

• Market Trends

An investor must have a sound understanding of the industry and peers to determine if a company has the potential to satisfy future market demands. This includes computing their moat or competitive advantage. Market trends are continuously evolving with each passing day.

Therefore, a smart investor keeps an eye out for companies with high growth prospects.  However, market analysis can be a challenging task. One must carefully evaluate the present market sentiments, including the industry specific sentiments, to determine its vulnerability to regulatory changes, by going through its law and policies.

• Draft Red Herring Prospectus (DRHP)

Every company has to submit a DRHP to SEBI before applying for an IPO. DRHP contains the company’s financial stats, current financial overview, management, policies, future plans, and prospects. The DRHP is thoroughly analysed and approved by SEBI. Only after its approval, a company can offer its shares to the public.

To access a company’s DRHP, you may visit the SEBI portal or respective company websites. However, investors must remember that a company may hide its drawbacks and focus on strong points to attract more investors. Therefore, it is always advisable to do your own market research online or by going through various credit rating agencies’ reports.

• Financial Ratios

To better understand a company’s hold over its finance and growth prospects you may want to look for some important ratios, such as Price to Earnings ratio, Price to Sales Ratio, Debt to Equity Ratio, etc. These figures let you assess various parameters such as the share returns, risks, and outstanding debt of a company. 

Therefore, you can easily profile overvalued and undervalued stocks accordingly. You can also consider the risk factor behind each investment and diversify your portfolio.

• IPO Intent

Companies list their shares to the public to raise funds for various purposes. These reasons include expansion, research and development (R&D), inventory upgradation, setting up production units, etc. These investments are progressive and add to a business’s growth. However, it is not always the case.

Some companies raise funds to repay substantial pending debts, resolve legal issues, or merely meet working capital. These investments do not add to a company’s growth and, therefore, do not profit its investors either. Therefore, you must clearly understand a company’s intent behind listing for an IPO and investing in growth-oriented companies.

Impact of an IPO on Valuations

IPOs play a major role in determining stock valuations. Let’s discuss some impacts of IPO on share valuation in various phases.

• Pre IPO

Unlisted companies can still raise their share prices through their projected growth, business plans, and high-earning prospects. Therefore, prospectus companies often attract private investors like venture capitalists who invest large funds in companies at discounted rates to avail larger returns post-IPO. 

Furthermore, venture capitalist investments are known to create hype among retail investors, which eventually pushes share demand.

• Post IPO

Once the shares are offered to the general public, the IPO value depends on the number of shares held by private investors and the general public.

• Stock Exchange

After the end of the IPO session, the stocks can now be freely traded on an exchange platform. Here its value stabilises and reaches its fair market price, depending on the demand-supply dynamics. At this point, the company’s valuation is its market capitalisation.

What Are the Positive and Negative Impacts of an IPO on Future Valuations?

IPOs can both positively and negatively impact a company’s share value. A well-performing company can attract a high opening price on the stock exchange. If investors do not sell off their holdings upon listing, the market demand and share prices can keep growing. 

However, this may backfire as well. In case the shareholders decide to sell off their equity right after the IPO session that may result in a high volume – low demand scenario. In that case, the company’s market capitalisation will go down.

Final Word

Investing in IPO stocks is a challenging task, due to its time-consuming nature and data unavailability. However, it can be equally rewarding if you can invest in an undervalued and fundamentally strong company. Company valuation is an important factor in this regard as it helps you find such stocks.

If you are a beginner, you may consult a financial expert to design a portfolio that suits your financial objective, as per your risk appetite. It is also advisable to adequately diversify your portfolio to minimise risks and yield greater returns.

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