How is an IPO Valued?

An IPO is when a company sells its shares to the public for the first time. However, to set a fair price for these shares, the company’s value must be determined. This involves assessing factors such as the company’s financial performance, market conditions, and future growth prospects. By analyzing these aspects, experts can decide on a price that reflects the company’s true worth, ensuring that the company and investors are treated fairly in the stock market. Moreover, to get an in-depth understanding of how is an IPO priced, there are several things that you must know. In this blog, we will understand the process of IPO valuation, factors influencing it, methods to calculate it, risks associated, and more.  

Key Highlights

• Several factors help determine the value of an IPO such as the financial performance of the company, which can also be affected by market force, demand from investors, the level of competition in the industry, and future growth prospects.

• The IPO can be valued using a range of methods such as relative valuation, absolute valuation, discounted cash flow (DCF) technique, and economic valuation. 

• Market dynamics including investor demand and economic conditions are the ones that determine an IPO price.

• Investing in an IPO carries risks such as price volatility, inadequate financial details, or following potential insider trading after lock-up periods.

Understanding an IPO Pricing

Establishing the initial price for a company’s shares during an IPO is crucial. Before deciding on this price, the firm along with its advisors and investment banks, assesses the organization’s financial standing, growth prospects, industry position, and competition. This process helps in valuing the firm and setting a fair share price. To attract investors and create interest, IPO prices are usually lower than market value. Apart from that, market conditions, demand from investors, and the amount of funds the company aims to raise affect the share price. 

On the IPO day, a price is determined at which investors can buy the shares. After that, these shares enter into the stock exchanges where their prices are determined by supply and demand. The price of the share may go up above the IPO if the IPO is successful and there is high demand for it. Whereas, if the demand is low or if changes in market conditions occur then its cost may go down. The performance of the shares after IPO can impact considerably on both the institution and those who invested early.

Process of IPO Valuation

Shareholders have to consider all aspects of the firm in making their decisions regarding the valuation of an IPO. For example, financial statements, physical possessions, mortgages, and rate of return.

So, first, a study is conducted, and then a judgment is made to prepare a prospectus submitted to the financial institution indicating when an IPO will take place. Hence, based on this shareholders fix the amount required for their stocks.

Factors Influencing IPO Valuation

An investor needs to understand the determinants influencing the IPO valuation. So, let’s discuss these factors in brief:

Market Situation

Prices of shares on the stock exchange are volatile. Usually, when the prices rise, everyone is making investments and hence it is called “bull money”. However, when they are going down it is referred to as “bear money”. This is because companies have to make requests for smaller amounts to win over investors.

Demand From Investors

This is one of the major factors that influences the price of an IPO share. Demand from investors means that if there is a high demand for the shares, the price will be high. Whereas, if there is less demand for the shares, its price will be low. Ultimately, making the IPO underpriced. 

Financial Performance

Investors usually go through the company’s financial records which include the revenue generated, cash, assets, and liabilities before deciding to invest in an IPO.

Industry and Competition

Industries like technology or automobiles may request high amounts of money for their IPO shares due to their demand in the market. However, this amount requested by the company can be verified by comparing the business to similar organisations in the market. 

Timing and Market

This is another major factor influencing the IPO share valuation. This is because if the economy is flourishing, the company may ask for high prices. Whereas, if the economy is weak, the company will be cautious in demanding a high price.

Regulations

It is crucial to have rules and regulations in place. Thus, companies need to follow certain guidelines made by SEBI to successfully launch their IPO. 

Growth Prospects

Large ambitions and anticipated growth increase the likelihood of companies seeking larger funding.

What are the Components of IPO Valuation?

Several important components are considered for the shares to be valued fairly. So, let’s discuss these components in brief:

Demand

According to experts, the most essential aspect to consider when determining an IPO price is the level of demand it attracts from different investors. The list contains institutional investors who acquire major stakes in firms and small-scale shareholders who are interested in fewer units of stock.

Industry Comparables

One of the other significant components is analysing the comparable firms in a similar sector that have already made their initial public offerings. Their stock values and market capitalisation will help in determining a reasonable price for the IPO of a company that will be launched.

Growth

The investors are also keen to see that there is a possibility of growth for the company. Investors can always determine whether a company is likely to grow and become more successful in the future by looking at certain indicators. These indicators can be profit margin, market expansion, financial projections, etc.

What are the Methods of IPO Valuation?

There are various methods through which an IPO is valued. Let’s discuss these methods in brief:

Relative Valuation

In this method, the banker compares the company to other organisations already quoted on the stock exchange to generate a figure. Principal aspects comprise price-to-earnings relation, monetary movement, and profit for each share.

Absolute Valuation

To evaluate the financial condition and strengths of the firm, it employs the Discounted Cash Flow (DCF) technique. A price is determined by considering the present worth of the company and its probable future earnings.

Discounted Cash-Based Valuation

Future cash flows, sources of revenue, and performance of the firm are estimated by specialists working together. This is a complicated process as little errors in the estimates may significantly influence the value of the company.

Economic Valuation

In this method, the company’s worth comes from its net income, liabilities, and assets.

Risks Before Investing in an IPO

An investor should acknowledge the risk involved in an IPO before investing in one. So let’s discuss them in brief:

Price Uncertainty and Volatility

In the first few days after an IPO, prices may fluctuate substantially, even doubling or halving the prices. This makes the stock prices more unpredictable. Therefore, this becomes the fact that most firms have not yet established financial track records. In turn, this poses obstacles to determining their level of security and anticipating and measuring their stability over time. Thereby, contributing to price fluctuations.

Lack of Information

The financial data of newly public companies is not as specific as that of already existing companies. This renders it difficult for potential investors to arrive at well-informed choices. After an IPO, there is usually a quiet period when the company and its advisors can’t share detailed information with the public. 

Insider Trading and Lock-Up Periods

The period after a company’s IPO during which company insiders are prohibited from selling their shares is called the lock-up period. Once this period is over, massive sales may increase stock prices. Sometimes speculative and consistent demand may make IPO pricing higher than its actual worth. Selling by insiders after the completion of the lock-up period can cause a decrease in share prices thereby resulting in losses for first-time investors. 

Conclusion

Valuing an IPO is a complicated operation that takes into account several factors including the company’s financial performance, market conditions, and growth potential. When setting the IPO price, it should reflect accurately the true worth of the company while balancing the interests of the company and potential investors. Moreover, by understanding these methods of calculating the price investors will be able to make informed decisions. However, there are risks associated with investing in an IPO including price variability, limited information at hand and possible insider trading following lock-up periods. Therefore, anyone thinking of investing in an IPO should consider the factors mentioned above to make informed decisions.

FAQs on IPO Pricing in India