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IPO valuation in-depth guide

The one big problem investors in a private company face when it comes to selling their stake is liquidity. Shares they own can't be sold to another private investor easily since it's hard to find someone willing to buy shares at the price they want.

Key Points

  • One of the reasons companies go public is for liquidity, in other words, for access to the public market.
  • The share price is usually fixed based on prediction of the price at which the market would accept shares, that is, market price.
  • Companies offer shares in the IPO based on predicted market price.
  • Company valuation is the product of price of one share and the total number of shares.

The one big problem investors in a private company face when it comes to selling their stake is liquidity. Shares they own can't be sold to another private investor easily since it's hard to find someone willing to buy shares at the price they want. This is because:

  1. Other private investors want to make as much money as they can from their investments. This brings down the offer price.
  2. The buying investor has to be convinced about the company's prospects and growth records.
  3. The buying investor has to find a market to sell the acquired stocks and has to face the same problems as mentioned above.

But, if there is a wide consensus among the public regarding the value of a company, with close scrutiny by analysts vouching for its credibility and projected future growth and potential buyers have the ability to sell the acquired shares to anyone in the public through the share market, it makes shares of a company much more valuable.

Thus, one of the reasons companies go public is for liquidity, in other words, access to the public market.

How does an IPO impact valuation?

Pre - IPO

Even at the stage where a private company contemplates filing an IPO, the company's value rises in the eyes of private investors for the following reasons:

  • The prospect of having access to the public market.
  • The prospect of being able to sell at a much higher market price after the company is listed.

After IPO

At the stage where the company files an IPO, its value is determined as follows: Valuation of an IPO = (No of shares held by private investors + No of shares sold to the public) x IPO offer price

After entry into the public market

After the IPO comes to a close and trading starts on a stock exchange, based on the demand - supply dynamics, the share price reaches a new normal, called the market price. Now, the company's value is equal to the market capitalization, that is, the price at which the company is valued by the market.

As we have seen, the company's valuation depends on the number of shares multiplied by the price of an individual share.

The number of shares to be offered is decided by the company. A figure is arrived at which does not dilute the private investors’ stake in the company substantially, while allowing the company to raise required capital.

How is share price determined?

The share price is usually fixed based on prediction of the price at which the market participants are likely to accept shares, that is, market price. This can be determined using the book building process where demand is gauged at varying prices within a price band (i.e. a certain price range) before a specific price is discovered.

Investors usually decide if it's worthwhile buying a company's shares based on certain indices such as price/earnings ratio, market capitalization/net income ratio. If the offer price is higher than the industry average, it means the company offers lesser returns per unit price compared to other companies in the same line of business. Thus, the offer price is deemed unreasonable. But price/earnings ratio don't remain the same and based on future growth projections, cash reserves, debts and liabilities, investors can bid at a higher price.

Impact of IPO on future valuation

IPOs affect future valuation of the company. Based on the hype surrounding an IPO and market demand during the IPO, the shares of a company can open at a higher price in the share market, leading to a greater valuation of the company. Also, if investors in the IPO don't sell large parts of their stake on the first day (flipping) and demand is sustained, the share price can reach a higher new normal. Also, IPOs filed during times when market demand is robust lead to a greater valuation.

IPOs can negatively impact company valuation too. That is, if shareholders start selling the shares they received during the allotment immediately after an IPO, then the opposite occurs. Thus, IPOs filed during periods of poor market demand or widespread flipping can result in a lower market capitalization.

Wrapping up

  • An IPO affects company valuation.
  • IPOs have an effect on a company's value during the pre - IPO, IPO and post - IPO periods.
  • Company valuation is the product of price of one share and the total number of shares.
  • Share price is determined based on the predicted market price.
  • Going public i.e. becoming an IPO can have an impact on the market price of the share.
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