Everything You Need to Know About IPO Pricing

A key aspect of any IPO is the actual pricing of the IPO. In the fixed price regime, the pricing decision was quite simple. You arrived at the price and that was the price of the issue. The investment bankers and the issuers decided the price. Nowadays, the trend has shifted predominantly towards book built issues. Under the book built issues, the investment banker and the issuer only determine an indicative floor price of the stock. The final price is determined through the process of book building based on the price level at which the maximum demand is elicited. That brings us to the core question; how exactly is the price /  floor price of the IPO determined?

What are the key factors that influence the pricing of the IPO?

  • What is the quality of the currently being sold in the IPO. If the company has a pedigree of belonging to an established industry group or is in a higher growth industry or if it has promoters and a board with marquee directors, then the pricing can be a little more aggressive. These factors work in favour of the IPO pricing.
  • A company with a clear organization structure, full created audit and compensation committees, marquee directors and auditors enhance the pedigree value of the company. A more defined and clear organization structure can work in favour of the pricing of the IPO.
  • The current market prices of the stocks of similar companies in the same sector also get into IPO pricing. You can call it the peer group or the peer comparison. For example, an IPO in the IT sector can possibly get a better valuation than in the oil services sector. Similarly, a company into emerging growth areas like artificial intelligence, cloud computing, genomics etc can command a better price in the market.
  • Present and future financials of the company will matter a lot. Markets give a lot of focus on companies that are generating positive cash flows from operations. Also if the company has a business model where the profit is likely to grow at a faster rate with unit growth in sales, then the IPO can command a better valuation.
  • The demand from the potential customers for company’s shares from retail, HNI and institutional investors also makes a difference to the pricing power of the IPO. These factors are gauged in the broker meets and the road shows of the IPO. If the market feedback is very positive then it gives a basis for a strong IPO pricing pitch.
  • Finally, the IPO pricing is subservient to the overall market trend: bullish or bearish?

An absolute approach to IPO pricing

In this approach to IPO pricing, the stock is essentially valued based on the economic value the company or stock can generated. That is why it is called absolute valuation approach. It is the process of estimating the company’s basic value by analyzing its fundamentals which are qualitative and quantitative. There are basically two approaches to absolute pricing.

Firstly, the discounted cash flow (DCF) method uses the net present value (NPV) of the anticipated cash flows from an investment. Revenue streams are projected based on a set of assumptions about the future business performance and forecasting how much of this performance can generate revenue.

Secondly, the Economic Value (EV) approach calculates the value of the company by focusing on its residual income, assets, risk bearing potential, and outstanding debts. This approach is generally used either when the company is loss making or when it is into high gestation projects or when you are looking at the company as an M&A target.

A relative approach to IPO pricing

Unlike the absolute approach to IPO pricing, the relative method focus more on the comparative metrics of valuation. Normally, the relative method is never used in isolation but it is used to ratify or cross check the valuations arrived at by the absolute method. It gives a market savvy to the entire rigorous valuation exercise. There are two ways here.

Firstly, P/E benchmarking is the most common method to determine share price. P/E is also the ratio of a company’s market capital to its annual income. This technique makes sense when the company is already making positive operating cash flows. Normally projected earnings based P/E is more meaningful compared to historical data, since valuations are all about the future.

Secondly, EV/EBITDA offers an alternate approach that you can adopt for IPO pricing. Here you look at the total business operations (enterprise value), instead of measuring the value of the equity. When the enterprise value is estimated, only the operational value of the business is considered. This is more suitable if you do not want the debt in the capital structure to unnecessarily skew your pricing.

Remember, that IPO pricing is an important decision. The issuer has a very delicate task to do. They need to maximize the price they get for the stock as it enhances the value of the company. At the same time, the company needs to leave something on the table for the investor. It is in between these two extremes that the IPO pricing decision is taken.

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