How is an IPO valued?

Also known as a public issue, an Initial Public Offering (IPO) is issued when a company wants to raise funds by selling its shares to the public. The company can use the funds raised via the IPO to meet its business expenses.

As an investor, one of the most important aspects of a public issue you need to pay attention to is the IPO valuation. A public issue with an accurate valuation is more likely to enjoy higher demand and perform better than an overvalued issue. This is precisely why companies often dedicate a lot of time and resources to value their IPO correctly. Read on to find out all about IPO valuation and how the share price is determined in an IPO.

What is IPO Valuation?

IPO valuation is an extensive process through which a company determines the price at which its shares are offered to the public for the first time. The issue price is determined by the company in consultation with the Book Running Lead Manager (BRLM) of the IPO.

Since the success of the issue hinges primarily on arriving at a valuation that strikes a balance between investor demand and maximizing the funds raised by the company, companies often view valuation as a critical step in the Initial Public Offering process.

What are the factors that influence IPO valuation? 

Several factors influence IPO valuation, determining how a company's shares are priced during its initial public offering:

1. Financial Performance: Strong revenue, profit margins, and consistent growth increase valuation, as they indicate financial health and stability.
2. Market Conditions: Overall economic conditions and stock market performance significantly affect IPO pricing. A bullish market often leads to higher valuations.
3. Industry Trends: Companies in fast-growing or popular sectors like technology or renewable energy generally receive higher valuations compared to those in slower-growing industries.
4. Growth Potential: The future growth outlook of the company, including market expansion plans, scalability, and innovation, plays a major role in determining its valuation.
5. Brand Strength and Reputation: Companies with strong brand recognition and positive public perception often command a premium valuation.
6. Competitive Position: A company with a unique competitive edge or dominant market share usually enjoys higher valuation due to its market leadership.
7. Management Team: Experienced and capable leadership can boost investor confidence, positively influencing IPO pricing.
8. Demand for Shares: If investor demand is high during the pre-IPO phase, the valuation often increases due to anticipated market interest.

Understanding the Valuation Process of an IPO

Knowing how a company arrives at its IPO value is crucial if you plan to invest in a public issue. This will help you assess the offer more accurately and encourage you to make a well-informed investment decision.

The IPO valuation process involves accounting for a plethora of different methods and factors. Let’s look at some of these key factors that help a company determine the price of its IPO.

• Absolute Factors

  Absolute factors are those that provide insights into the company’s financial performance and fundamentals. Revenue, cash flows, assets, liabilities, profitability, future growth potential and economic value are a few examples of absolute factors. The Book Running Lead Manager, along with the issuing entity, examines past financial statements and future earnings and growth potential comprehensively to determine the IPO valuation.

• Relative Factors

  Relative factors are those that enable investors to draw comparisons between the company offering the IPO and other similar entities. Price-to-Earnings (P/E) ratio, Debt-to-Equity Ratio, Price-to-Earnings-to-Growth (PEG) ratio and Return-on-Equity (ROE) are some of the key examples of relative factors. Companies offering public issues often do extensive comparative analysis with their rivals and industry peers to arrive at the IPO value.

• Discounted Cash Flow Analysis (DCF)

  Discounted Cash Flow Analysis or DCF is a method that companies regularly use to determine the present value of their predicted future cash flows using the time value of money. The discounted cash flows arrived through this method are factored into the calculation of IPO value along with the company’s present cash flows.
  That said, the DCF method is not without its flaws. The projected future cash flows that the method uses may not materialize, which can skew the result significantly. Therefore, as an investor, you need to account for such situations when analyzing a company’s IPO valuation.

• Industry Dynamics

  Industry dynamics is another very important factor that the IPO issuing entity and the BRLM consider when arriving at the price of the public issue. A company operating in a complex industry with high barriers to entry is likely to command high valuations.
  Comparatively, a company operating in an industry with little to no entry barriers is likely to be valued lower. In addition to this, companies also consider other connected factors like the number of competitors, market share and regulatory involvement when ascertaining industry dynamics.

• Market Sentiment

  Market sentiment is often one of the most influential factors that determine an IPO’s valuation. It can be defined as the collective attitude of investors in the market and can either be optimistic, pessimistic or neutral. Market sentiment is influenced by a range of different factors like economic data, earnings reports, geopolitical events and central bank policies, among others.
  When the market sentiment is optimistic, companies often tend to set a high IPO valuation since investors would be more likely to invest regardless of high valuations. On the other hand, when the market sentiment is pessimistic, companies either set a low IPO value or cancel their plans to go public entirely since investors would generally want to remain on the sidelines.

Key Terms for IPO Valuation 

Here are some key terms commonly associated with IPO valuation:

1. Earnings Per Share (EPS): This is a measure of a company's profitability, calculated by dividing net income by the number of outstanding shares. A higher EPS often indicates a more valuable company.

2. Price-to-Earnings (P/E) Ratio: This ratio compares a company's share price to its earnings per share, helping investors assess whether a stock is overvalued or undervalued compared to its earnings.

3. Book Value: This represents the net asset value of the company, calculated by subtracting total liabilities from total assets. It's used to evaluate the fundamental worth of a company.

4. Market Capitalisation: The total market value of a company’s outstanding shares, calculated by multiplying the stock price by the number of shares outstanding. It reflects the company’s overall size and value.

5. Discounted Cash Flow (DCF): A valuation method that estimates a company's value based on its expected future cash flows, discounted back to the present value.

6. Enterprise Value (EV): A measure of a company's total value, including market capitalisation, debt, and cash reserves. It gives a broader view of the company's worth.

7. Revenue Multiples: Used to value a company based on its revenue, this metric compares a company’s market capitalisation to its revenue, often applied in industries with high growth potential.

8. Free Float: The proportion of shares available to the public for trading. A higher free float can positively influence market liquidity and impact valuation.

9. Underpricing: This refers to the practice of pricing an IPO lower than its expected market value, often done to ensure full subscription and a strong market debut.Understanding these key terms is essential for evaluating and analysing a company’s IPO valuation effectively.

Why Is It Important For An Investor To Know How Ipo Is Valued? 

It is important for investors to understand how an IPO is valued for several reasons:

1. Assessing Investment Potential: Knowing the valuation helps investors gauge whether the IPO is priced fairly or if it's overvalued or undervalued. This can influence their decision to invest.
2. Managing Risk: IPO valuations reflect the company's financial health, growth potential, and market conditions. By understanding the valuation, investors can assess the risk involved and make informed decisions.
3. Maximising Returns: A well-understood IPO valuation allows investors to invest in companies with strong growth potential, leading to better returns over time. It also helps in identifying whether the shares are likely to appreciate.
4. Comparing to Peers: Valuation provides a way to compare the IPO company with other companies in the same sector, helping investors decide if it's a better investment opportunity than competitors.
5. Market Timing: Investors can use valuation insights to time their entry into the market, ensuring they don’t overpay at the time of the IPO and can potentially capitalise on early gains.

By understanding IPO valuation, investors make smarter, more strategic decisions, ultimately improving their chances of success in the stock market.

Conclusion

With this, you must now have a good understanding of how share price is determined in an IPO. Companies offering their shares to the public for the first time usually tend to be cautious while determining their value.

Overvalued public issues often don’t perform well and undergo significant market correction when the shares are finally listed on the market. Meanwhile, the chances of share prices rising after listing are high with undervalued and appropriately valued public issues. Therefore, if you’re interested in investing in an IPO, remember to take the time to evaluate the share price to determine whether it is appropriate or not.