Personal Finance

How is an IPO valued?

February 4, 2021

How is an IPO valued?

The company’s initial public offering (IPO) price is the value per share of stock given to the company once it starts to trade publicly on the stock exchange. To figure an appropriate IPO value for the stock, company leaders and investment banks analyze the performance and health of the company.

The entire IPO valuation is normally done according to the rate of demand and supply in the trade market. Usually, an IPO is sold at a certain price that the investor is willing to buy at.

Process of IPO valuation

To value IPO, investment bankers compile all data and go through the financials of a company, its assets and liabilities, revenue generation, and performance in the market, besides other parameters. These data are thoroughly analyzed over a period of time before it is submitted for an official audit. Based on this audit, a prospectus is filed with the concerned stock exchange, an offering date is scheduled, and the price of the IPO is determined.

Factors affecting IPO valuation

Here are certain key factors that affect the price of the offered shares for an IPO:

  • The number of stocks that are being sold in an IPO.
  • Potential growth rate of the company.
  • Financial performance of the company over recent years.
  • Company’s business model also applies as an essential factor.
  • Demand from potential customers for the stocks being sold.
  • The current market price of companies listed in the same sector.
  • Overall share market trends.

IPO Valuation Methods

The IPO valuation process, irrespective of the chosen methods, is strenuous and requires a lot of experience, conscientiousness, and good market understanding. SEBI examines very carefully each and every IPO application from all the nooks and crannies, to ensure that the money invested by the public is going into the capable hands, for an earnest cause at an appropriate value. There are different valuation methods of an IPO that are employed in defining the share value –

Economic Valuation

This is a complete mathematical valuation where a set of predefined parameters are considered. These parameters comprise the residual income of the business, debts to be paid off, the value of assets owned and liabilities to get rid of, risk-bearing potentials, investments, and so on.

Price-to-Earning multiple

This method compares a company’s market capitalization to its annual income. To determine the actual value of the company, its evaluated equity value is divided by its current net income to find out the price-to-earnings multiple. However, this method is mostly employed when the company has positive cash flows and when other businesses belonging to the same industry have growth and capital structure along the same lines.

Relative Valuation

Under this relative valuation method, a company’s share value is determined by taking into consideration the value of similar companies. This method of valuation needs the experts to watch at the closer benchmarks in their industry, ideally, the companies that are already listed on the stock exchanges. Relative valuation is also known as the comparable valuation method.

Absolute Valuation

Absolute value describes an IPO valuation method that is used in measuring the financial status and strength of a company. This method of business valuation uses Discounted Cash Flow (DCF) in assessing the wealth of a company.

However, the absolute valuation of a business differs from its relative valuation. While an absolute value examines a company’s wealth using the time value of money and accumulation of interest, the relative value method measures a company’s wealth by comparing it to its competitor’s wealth.

Discounted cash value based valuation

In this method, the team of experts makes various analyses in terms of expected cash flows, forthcoming performance, business investment, potential revenue sources, and so on. Though this requires a lot of hard work in understanding the business performance, all these analyses made must have an appropriate justification.

Conclusion

Hence, when evaluating the price of an IPO it is about the valuation of the company rather than the price of a share. Once listed, the share price is affected by several factors, including economic conditions and general market sentiment. The movement in the price of the share is then reflected in a corresponding movement in the company’s valuation (market capitalisation).
Additionally, investment bankers use different financial models and value the company that is going public via the IPO route. Sometimes, they also need to unlock a combination of several methodologies to get it done right.

However, it is up to an investor to do a detailed analysis before applying for the issue. Investing in an IPO based on rumors and recommendations is not the best approach. Instead, as an investor, studying the company’s fundamentals, history, trends, and financial statements is good practice.