How an initial public offering (IPO) is priced?

A lot of private companies go the IPO way to raise fresh capital for operations. When a company goes public, i.e., when it files for an initial public offering (IPO), its shares are available to the general public for the first time. Thereafter, its stock gets listed on the exchanges and is traded publicly in the primary markets.

Many investors are increasingly drifting towards IPOs in the hopes of making quick and good money. A company that looks to get listed has to price its IPO. Now, how the company is valued is determined by a number of things. For those who wish to become early investors in a company, understanding how an IPO valuation is conducted is important.

Pricing of shares of a company going public

In India's primary market, shares are valued basis a free pricing mechanism. There is no role played by any market body or regulator in the fixation of price of market securities. When a company files for an IPO, it hires a merchant banker in an advisory role, to help with the process. One of the functions performed by a merchant banker is to conduct due diligence on the company and then help it fix the IPO price.

How the company arrives at a certain share price is part of the disclosures made in the offer document of the public issue. The parameters taken into account for the same are also outlined in the document. Basis the manner of pricing of an IPO, it can either be a fixed-price issue or a book-built issue.

Fixed price issue and Book built issue

When an IPO share issue price is fixed right at the outset and mentioned in the offer document, the IPO is categorised as a fixed price issue. But, if the price of the public issue is determined based on the demand for shares among prospective investors, the IPO is termed as a book-built issue. Here, investors are provided with a price band and range within which they can place their bids. Basically, market forces determine the price of a company's share in a book-building process.

An issuer (the company) is required to disclose the price band at least 5 working days prior to the opening of an issue subscription. In case of a book-built issue, these details (floor price, price band, etc.) are available in the red herring prospectus while the same is available in the draft prospectus in a fixed price issue.

Factors that influence IPO pricing

One of the main things that influence the price of an IPO is market demand. Most companies launch their IPOs at a time when the demand for the stocks of a certain segment is relatively high. A higher IPO valuation is thus often a matter of good timing.

The growth prospects of a company and its past financial performance also play a key role in the pricing of an IPO. The service or products on offer also determine the value ascribed to a company. The value of shares of market or industry peers can also influence investors' early reaction towards a company's stocks.

References:

https://www.sebi.gov.in/sebi_data/commondocs/subsection1_p.pdf

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