How is an Initial Public Offering (IPO) Priced?

How is an IPO Priced or Valued?

A significant number of private companies raise capital through an Initial Public Offering (IPO). When a firm files for an IPO, its shares become available to the public for the first time. The company’s shares then list on the exchanges and trade openly on the primary markets.

During the application procedure for an IPO, the company’s owner determines the number of shares that they want to offer through the issue. The company then employs a merchant banker to evaluate its financial report card, business prospects,  management style and potential risks in order to decide the IPO price.

Although the process of IPO valuation may appear simple, it is not. On the one hand, an overvalued initial public offering could fail to attract enough investors, causing the company to lose a substantial amount of money and credibility. On the other hand, an undervalued IPO may fail to attract Qualified Institutional Investors and Non-Institutional Investors or may make investors question the IPO pricing. Thus, it is critical to determine the right price for the offer.

Recommended Read: IPO Process in India

What are the IPO Pricing Methods?

The valuation of an initial public offering is a complex task. Thus, merchant bankers and financial professionals are hired to determine the IPO price. Before giving the go-ahead, the Securities and Exchange Board of India (SEBI) reviews every aspect of the IPO application. Following are the different IPO pricing methods:

Relative Valuation

In relative valuation, you can determine the share value of a firm by comparing it to the value of already listed similar companies. In this approach to IPO valuation, the sector benchmarks and companies previously listed on the public exchanges are meticulously examined. The valuations of already public companies help in determining the optimal price. This valuation considers the company’s cash flow, price-to-earnings ratio, and earnings per share (EPS).

Absolute Valuation

The absolute valuation approach helps determine a company’s financial health and strengths. This method of IPO valuation uses Discounted Cash Flow (DCF) to analyze the company’s wealth. Absolute valuation considers a company’s wealth using the time value of money and interest accumulation to determine its share value.

Discounted Cash Valuation

Numerous financial professionals examine the organization’s estimated cash flows, possible income sources, future performance possibilities, etc. This strategy requires a great deal of effort and comprehension because it analyzes corporate performance and must be adequately justified. Thus, it is more difficult than the relative or absolute valuation methods since an inaccurate estimate may increase or reduce the value of the company.

Economic Valuation

Economic valuation is an essentially mathematical process that takes into account a set of criteria. The merchant banker evaluates multiple characteristics, such as the residual income of the business, its debt position, the net value of its assets, risk-bearing potential, etc.

Price-to-Earnings Multiple Valuation

This method compares market capitalization to the annual income of a company. The price-to-earnings multiple is calculated by dividing the company’s estimated equity value by its current net income. However, this strategy is typically useful when a company has positive cash flows and when other companies in the same industry have comparable growth and capital structure.

What are the Factors Influence the IPO Pricing in India?

The core values of demand and supply govern the initial public offering’s price. The greater the demand for the company’s shares, the higher the price will be. In addition to demand, there are other factors like competitors, growth potential, and the company’s corporate story that play crucial roles in establishing the IPO price.

Following are the key factors that influence the IPO pricing in India:

Demand

Demand relates to how attractive the IPO is to investors. In May 2022, LIC went for its IPO. LIC is India’s fifth most valuable company. With an IPO price band of INR 902 to INR 949 and an issue size of INR 21,008.48 Cr. The issue was oversubscribed by 2.95 times. However, the share’s listing price was INR 865 (at an 8.62% discount). This demonstrates that demand is not a completely reliable measure of a company’s value. However, investors frequently consider demand before participating in an IPO.

Explore our article on What is IPO Listing?

Competitors/ Peers

It’s a common practice for analysts and investors to compare the company going public with listed competitors. They compare the IPO price to the current market value of the competitors and determine if the share is overpriced. The price comparison will help in determining if the company is worth investing in or not.

Growth Prospects

The growth potential of a company also plays a significant influence in setting the IPO price. Typically, companies raise capital from the market to fund their business goals and fuel their growth. However, valuations may be relatively low if a company’s principal reason for going public is to consolidate its debt. Investing in a firm with a solid growth narrative is more preferable for investors. Moreover, companies that effectively illustrate their growth may be popular among investors.

Economic Factors

Sometimes industry narratives can impact IPO pricing more than quantitative data. For instance, the COVID-19 epidemic refocused attention on the pharmaceutical sector. This can automatically raise the valuation of an IPO-launching pharmaceutical company. Similarly, the economic set up in the country largely plays a role in the price determination and demand for an IPO.

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