How Is An IPO (Initial Public Offering) Priced?
Launching an IPO has become a very popular method to raise funds in case private companies are willing to be public companies. As an investor, subscribing to the company's IPO means getting a proportionate share of its ownership. If you get the allotment of the shares, you will be able to participate in its profits and losses, and you will be able to get a dividend as a part of the company's profitability.
What is an IPO?
Before understanding the methods of pricing an IPO, we need to understand what an IPO is. It is a process of offering to buy shares of a private company from the general public for the first time to raise funds. Investors who hold shares of the company become proportionate owners, which helps them grow their money over time, corresponding to the company's growth.
Benefits of an IPO to the company
When a company is looking forward to accomplishing a big vision, like further expansion, they require a huge capital investment, which is impossible through personal relations or even venture capitalists. Launching an IPO would be helpful in:
- Getting funds to expand its operations
- When a company goes for an IPO and gets oversubscribed due to strong fundamentals and a clear vision, it gets popularity among investors. Investors will be more likely to invest for the long term in the company.
- Awareness among the investors also helps the company generate customers, as individuals don't only invest in the company but also buy.
- Fund raised through an IPO can be utilised for an excellent cause to buy additional property, plant, and equipment (PPE), fund research and development (R&D), expand, or pay off existing debt.
Who prices the IPO of a company?
When a company is interested in an IPO, it must make it possible through merchant bankers. They will get involved in every aspect of the IPO, including document preparation, registrar filing, marketing, issuance, evaluation of financial statements, adequate disclosure of the material information in the prospectus, and most importantly, fixing of IPO share price. All the IPO proceeding has to be done by the merchant itself.
What are the methods to set a price of an IPO?
Before investing in an IPO, one thing we usually have to keep in our minds is the right value of shares, i.e., whether it is rightly priced or over/under priced. Merchant bankers priced an IPO in two ways: Fixed price offering and book building price offer.
Book building offering
The merchant banker establishes a pricing range for the book building offering, usually referred to as a price band. The floor and cap prices are on opposite sides of the price band. So, a book-building IPO price might range between Rs 900-1200 per share. At the time of application, investors can choose the price and the number of lots they want to apply for. While during the allotment, the highest price range is fixed by the company, and you will receive the allotment if you have applied for that particular fixed price.
Fixed price offering
On the contrary, in the case of fixed price offerings, merchant banks fix a specific price, say Rs. 900 per share. Investors have to pay a particular price to apply for a particular share.
Now, the question is how merchant bankers come up with a price band or a specific share price. How do they know that a particular share is worth Rs 900 per share?
For the purpose of IPO valuation, there are various methods used by merchant bankers to value an IPO, depending on the type of company and information available. These methods are as follows:
Relative valuation of an IPO
Typically, the merchant banker determines the optimal price by examining the valuations of the already publicly traded companies. Here, elements like the price-to-earnings ratio, cash flow, and earnings per share are to be taken into consideration. In the relative valuation method, the value of an IPO is determined on the basis of other companies' valuations. For this form of appraisal, the specialists must keep an eye on the closest industry benchmark, ideally the businesses that are already listed on stock markets.
This is the primary reason the relative valuation method is also known as the comparative valuation method.
Absolute valuation of an IPO
In the case of absolute valuation of an IPO, merchant bankers analyse the financial position and strength of the company. In order to determine a company's wealth, the approach of business valuation discounted cash flow (DCF) is followed by merchant bankers.
But a company's absolute value is different from its relative value. The relative value approach evaluates a company's wealth by contrasting it to the wealth of its rivals, as opposed to an absolute value method, which looks at a company's wealth using the time value of money and the accumulation of interest.
Discounted cash value based valuation of an IPO
With this approach, the team of financial experts does numerous assessments regarding projected cash flows, future performance, corporate investment, possible revenue sources, etc. Even if it takes a lot of effort to comprehend how the firm is performing, all evaluations must be properly justified. Since an inaccurate estimate could result in a rise or decrease in the company's valuation, this method presents more of a challenge than the relative or absolute valuation methods.
Economic valuation of an IPO
In the economic valuation of an IPO, merchant bankers assess various economic factors of the company to determine the true value of the IPO. It takes the help of residual business income, debt status, and the net value of assets owned to derive a real value of the IPO.
How is IPO valuation essential to look at before investing in it?
- It gives you a clear understanding of which factors are taken into consideration by the merchant banker while valuing the IPO and which aspects are ignored by them. It will help investors understand whether such an ignored factor is relevant to the company's growth or adversely affects the market price in the secondary market after launching the IPO.
- As an investor, you can evaluate whether such a company is underpriced or overpriced. Both of the situations play a vital role in making investment decisions. Buying overpriced shares might get you into losses, and underpriced shares might help you get shares at a discounted price if the company's fundamentals are strong enough to sustain and grow.
Factors affecting the pricing of the company
Potential growth of the company
Investors are more likely to invest in a company whose potential growth rate is higher than or at least equal to other companies in the same industry. If you are a long-term investor, your money grows in correspondence with the company's growth.
Financial performance of the company
If the past financial record of a company is reliable and sound enough, as an investor, you will definitely apply for such a company's IPO. But if a company's financial performance is not sound, like debts are underpaid, there would be a high chance of unwillingness to invest in the company.
The sound financial position of the company attracts more investors.
The macroeconomic conditions of the country
Many companies have postponed their IPO launching dates as economic conditions of the country are leading to a recession, the stock market is already in a downtrend, and investors are selling shares rather than buying because of inflationary conditions. Investors do not have much money to invest after dealing with their regular expenses. Also, due to negative returns in the market, new investors are not entering the market. Such a broad view of the stock market also affects the pricing of an IPO.
By concluding the whole article, it can be said that evaluating an IPO is not only related to the shares. Rather, it is related to the valuation of the whole company. Investors generally do not invest in an IPO. They invest in the company's performance, growth potential, and financial status.
FREQUENTLY ASKED QUESTIONS (FAQs)
Q. How is the initial public offering calculated?
A merchant bank determines the IPO price. The company first chooses how many shares it intends to sell to the general public. The chosen merchant bank then performs a thorough evaluation of the company.
Q. What is the cut-off price in an IPO?
A cut-off price is a price at which the investors get the shares, in the case of a book-building method of fixing the IPO share price.
Q. Who loses when an IPO is underpriced?
When an IPO is underpriced, the company which is launching an IPO loses the money. Underpricing IPOs costs the issuing business money while gaining money for the underwriters and potential investors. Investors who have applied for the shares get the shares at discounted prices, and the share price will increase after launching an IPO. Now, investors have an option to sell the shares at premium prices.
Q. Are most IPOs underpriced?
There is strong evidence that new share offerings, or IPOs, are typically underpriced. In other words, when shares of a company are first made available to the public, their prices are typically set lower than what investors are willing to pay when the equities begin trading on the secondary market. It helps companies attract more investors to invest in their company so that their shares can get oversubscribed.
Q. What is a hot IPO market?
An initial high-demand public offering is referred to as a hot IPO. These initial public offerings are well-liked, generating significant interest from investors and the media even before they are released to the public. Following the company's IPO, share prices typically experience a considerable increase as a result of publicity and hype.