How is an IPO valued?
Investors love Initial Public Offerings (IPOs) as they have the potential to offer good returns in a short time. Numerous companies come with their IPO almost every week, looking for investors to apply and help them raise adequate funds. However, as the shares list on the stock exchange, they may see volatility, which can lead to losses for the investors.
That said, if you understand IPO valuation, the chances of the shares providing you profits are higher. This blog will help you learn everything about IPO valuation.
What does IPO valuation mean for an investor?
When a company launches an IPO, its main motive is to raise funds. Generally, companies use the funds they raise from an IPO for reasons like business expansion, paying salaries, or repaying debt. However, the owners privately hold 100% of the company's shares before an IPO. They have to decide the number of shares they want to offer to the general public during the IPO, which lowers their share ownership. The company hires a merchant banker who oversees the whole IPO application process and consults with the company to determine how much each share should be priced in the IPO.
A merchant banker uses two IPO valuation methods to determine the price of each share: the fixed-price offering and the book-building offering. In the fixed-price offering method, the shares are offered at a fixed price. For example, the share price in an IPO can be Rs. 100 under the fixed-price offering.
In the book-building offering, the company sets a range called the price band, which includes floor price and cap price. For example, a price band looks like Rs. 100-110, where Rs. 100 is the floor price, while Rs. 110 is the cap price. The company chooses a cut-off price in IPO within this range and issues the shares at that price.
Once the company completes the IPO valuation calculation, it is up to the investors to analyse the IPO and decide what it means for them. The best way to do this is to read the Red Herring Prospectus (RHP), a detailed document released by every company that includes everything about the company and the IPO. You can download the RHP from SEBI’s website.
Once you have analysed the RHP and understood the nature of the business operations and the reason for which the company wants to raise funds, you can analyse the IPO valuation. The IPO value sheds light on the future growth opportunities, the company’s business prospects, and its financials.
An overpriced IPO means that investors may avoid applying to the IPO, and the shares can open at a discount, resulting in losses. On the other hand, if the IPO is underpriced, it may not see investments from other expert investors, such as QIIs and NIIs, resulting in the same discount listing. Hence, for investors, IPO valuation means that the shares should be priced at a balanced level for them to list at a premium.
What are the components of IPO valuation?
Numerous factors govern IPO valuation:
Demand is one of the most important factors in determining IPO valuation. If the company is a well-known brand and people know its products or services, it is expected to see higher demand. Higher demand means that the IPO application may get oversubscribed (a situation where more applications are received than the shares offered). However, an IPO with a higher demand doesn’t necessarily make its shares listed at a premium.
Growth potential is a crucial factor as companies generally raise funds through an IPO to expand their business. If the IPO is for expanding the business, the IPO valuation might be high. However, suppose the company is raising funds to pay off its debt. In that case, the IPO valuation might be low as investors prefer to invest in an IPO of a company with effective growth potential.
The availability of competitors in the market is also a factor in IPO valuation. If a company that is launching an IPO has multiple direct competitors, you can easily compare their businesses to determine the company’s market value. If one or two competitors already have their shares listed, you can compare the prices and determine if the IPO is overpriced and refrain from applying.
The last factor is the stock market scenario, which affects the current investor sentiments. For example, if the market is experiencing a bear run (stock prices falling), investors may feel that the shares may list at a discount. On the contrary, if the market is experiencing a bull run (stock prices rising), the IPO may see higher valuation and demand.
What are the methods of IPO valuation?
There are five IPO valuation methods of IPO valuation calculation. These are:
- Relative valuation: The merchant banker analyses the valuations of already-listed companies to decide the per-share price in the IPO.
- Absolute valuation: The merchant banker assesses the company’s strengths, wealth, and financial condition to decide the per-share price in the IPO.
- Discounted cash-based valuation: The method sees numerous financial experts coming together to evaluate the company’s future growth, potential revenue sources, etc., to determine the per-share price.
- Economic valuation: The merchant banker analyses the company on economic factors such as debt status, business income, asset values, etc., to set the per-share price.
Conclusion
Initial public offerings are one of the best ways to invest in stocks, as they can provide hefty returns in a short period. However, as there have been numerous instances of IPOs listing at a discount and resulting in losses, it is important that you analyse the IPO value before the IPO allotment process and then decide on applying to the issue.
