How does an IPO get priced?

Introduction:

Do IPOs go down? Yes, they do. Do they predominantly go down? Not really. What does the primary cause for IPOs to see a failure? Well, it is the overpricing of the IPOs, which makes investors buy averse. And this very statement deciphers the criticality of the IPO pricing. The article gives an overview of how the pricing of an IPO is decided.

IPO pricing is one of the most sensitive issues in the whole IPO process. It is a two-edged sword. Too highly-priced IPOs may turn out as a failure, as investors may not be interested because of their high price. And for too low-priced IPOs, the IPO firm may bear the cost in terms of foregone capital.

For an IPO to be appropriately priced, the business/firm has to be fairly valued by an expert. Three processes are extensively used for the said purpose: Financial Modelling (Discounted Cash Flow Method), Comparable Company Analysis, and Precedent Transaction Analysis.

Financial Modelling:

A financial model is a simple tool, built-in MS Excel, to forecast the financial performance and valuation into the future. The forecast is typically based on the Company’s historical performance and assumptions about the future. It requires preparing an income statement, balance sheet, cash flow statement, and supporting schedules. That is fundamental. From here, the more advanced models such as Discounted Cash Flow Analysis (DCF Model), Leveraged Buyout (LBO), Mergers & Acquisitions (M&A), And Sensitivity Analysis have emerged.

The downside of using this method is: it is based on several assumptions, some of which could be random.

Additional Read: Upcoming IPO calendar

The Comparable Company Analysis Approach:

Comparable Company Analysis is the most commonly used valuation methodology that looks at the ratios of similar companies. As the name suggests, it is the relative form of valuation. Investment Banks frequently use this approach when pricing an IPO. A selected list of firms is compared to the IPO firm regarding industry classification, geography, size (revenue/assets/employees), risks, growth prospects, and profitability.

The leading information in the comparable company analysis includes:

• Company Name
• Share Price
• Market Capitalization
• Net Debt
• Enterprise Value
• Revenue
• EBITDA
• EPS
• Analyst Estimates

Valuation multiples such as Price-to-Earning ratios (P/E ratios), Price-to-Sales ratios (P/S ratios), and Market-to-Book ratios (M/B ratios) are then used to compute the issuers’ price per share. Once the comparable firms and their financial ratios have been identified, the next step is to arrive at the appropriate equal ratio for pricing the IPO firm.  However, it has its downside too. It creates several challenges when selecting the comparable firms or the proper financial ratios of these firms.

Additional Read: All you need to know about IPO application process

Precedent Transaction Analysis:

This method is used to do Company Valuation, where past Mergers & Acquisition transactions are used to value a similar business today. It is commonly referred to as precedent. Here the screening process is based on industry classification, type of the Company, various financial metrics, geographical dispersion, company size, product mix, kind of buyer, deal size, valuation, etc.

Conclusion:

To summarize the whole show, it can be said. For pricing any financial assets to be traded in the market, the primary determinant is the essential supply and demand forces. And the same applies to the IPOs with no exceptions. Stock valuation experts figure out the stock worth and whether it will capitalize on the market or not if the stock is traded at a discount.

Additional Read:

• https://www.icicidirect.com/knowledge-center/article/how-an-initial-public-offering-ipo-is-priced/18626
• https://www.icicidirect.com/knowledge-center/article/oversubscribed-definition---ipos/18643
• https://www.icicidirect.com/knowledge-center/article/what-is-an-undersubscribed-ipo/18706

Disclaimer: