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How is an IPO Valued

How is an IPO Valued?

IPO valuation is an important part of the IPO process because the price of the IPO is decided based on the valuation. The IPO valuation serves as the guideline for the company management and the investment banker to arrive at an acceptable valuation of the company. This is then adjusted and used as the basis for pricing the IPO.

Why IPO valuation is a very delicate trade-off

What do we mean when we say that IPO valuation is a trade-off? There are two opposing forces at work here. Promoters and early investors will want to get the best possible valuation as it will determine the future course of the stock price. However, the investment bankers and the company must also leave some returns on the table so that IPO investors will continue do remain interested in the IPO. If valuation is set too steep, it does not excite the IPO investors too much.

How is the IPO valuation done in practice?

Earnings projection
The first step to valuing the IPO is to look at the future earnings of the company. Obviously, any valuation that we assign to the company today must be justifiable by the P/E ration in terms of future earnings for the next 3-5 years. Unless revenues and profits are there in the next few years to back up the valuation, investors may not be too interested.

Industry P/E benchmarks
The second step is to look at benchmarks in terms of the industry group to which the company belongs. For example, if mini steel plants are quoting at an average P/E ratio of around 8X then a mini steel plant IPO cannot be brought at a P/E Ratio of 16X. Obviously, the investors will not be keen to buy the IPO at such steep valuations.

Understanding business of the company
Does the company bring some unique strength to the table? These strengths can be in the form of some unique brand or some specific product line that has no competition. It could also be an advantage in the form of entry barriers it has created in the industry. Such positive factors will help the company get a higher valuation for its IPO.

Justifying the issue premium
The investment bankers may also suggest a premium offering if the company has some disruptive product which has huge potential in the next few years. In the US we have seen companies like Amazon and Facebook coming out with IPOs at very steep valuations because they had managed to disrupt their respective businesses. This can justify higher valuations.

Channel checks
Last, but not the least, the investment bankers will do a field check with the distributors and the brokers on whether the issue will be marketable at a particular price. This will also depend on factors like the state of the market, the news flows pertaining to the sector, the flows from domestic and global institutions etc. When these are supportive, the company can command better valuations.

3 Rules to Guide the Final Valuation Before Setting the Price Band

The price band is predicated on the indicative valuation for the company that the investment bankers arrive at. There are 3 things to be kept in mind here…

Consider qualitative factors
Valuation is a lot about qualitative factors. While methods like discounting of future cash flows and PECV are fine, there are qualitative factors like brands, quality of management etc that are a lot more important. A combination of tangible and intangible factors will typically give the best results when it comes to valuations.

Price band setting
There is a fairly subjective judgement involved when it comes to setting the price band for the stock. The valuation can at best be a guide but it only captures the quantitative factors. The price has to be set based on the qualitative factors and also the margin of safety that the company and the investment bankers want to leave on the table for the investors.

Leaving returns on the table
Finally, the price band is a trade-off between the need for good valuations and the practical merit in leaving upside potential for the IPO investors. That is the basis for fixing the price band.

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