Whenever we read or hear about IPOs, the company¡¯s financial performance and objective behind going public are among the first things one must know about. But what will anchor the amount you need to pay for investing in an IPO, are the company¡¯s share price band and valuation.
So how is the company¡¯s share price and valuation in the IPO determined? And why is it important to know about it??
Curious to know? Read on as we decode the same for you.
Also Read:?Decoded: Why Companies List Shares On The Stock Market
A successful IPO usually hinges on consumer demand for the ¡®soon to be public¡¯ company's shares. Strong demand for the company is expected to lead to a higher stock price and vice versa. But that¡¯s not all. In addition to the demand for a company's shares, there are several other factors which anchor an IPO valuation.?
Let us understand how demand, industry comparables and growth prospects are among the factors that impact the IPO valuation and share price.
Strong demand for a company's shares does not necessarily mean or guarantee that the company is more valuable. However, it does imply that the company will have a higher valuation. An IPO valuation is the process by which financial analysts/experts determine the fair value of a company's shares.
Even two identical companies may have very different IPO valuations simply because of the timing of the IPO and market demand. Generally, a company will undergo an IPO when they determine that demand for their stocks is high. That¡¯s why many companies tend to go for IPOs when they expect that the demand for their stocks is trending and high.
Another aspect of the IPO valuation process is the industry comparables. If the company intending to go for IPO is in a field that has comparable publicly-traded companies, the IPO valuation is likely to include a comparison of the valuation multiples being assigned to its competitors in the industry.?
The rationale behind comparison with industry is that investors will be willing to pay a similar amount for a new entrant into the industry as they are currently paying for existing companies in that sector/industry.
An IPO valuation also depends on the company's future growth projections. As the primary motive behind rolling out an IPO is usually to raise capital to fund further growth, the successful sale of an IPO and the determination of the share price band often depends on the company's projections and whether or not it is looking to and can expand. As an investor, you can check the IPO objectives in the prospectus. Other reasons for rolling out IPO can be debt repayments, exit route for?early investors, etc.
Investors are generally advised to invest in companies with healthy business models and clear growth prospects. This is because such companies have a bigger scope of generating profits on a sustained basis, which can yield better dividend gains, besides appreciation in the market value of the stock.
Also Read:?5 Big Blunders To Avoid When Investing In Any Company's IPO
Two approaches are usually adopted for valuation of stock prices of a business or company.?
In the absolute valuation approach, the present value of the business or company is determined by estimating the future income sources using Discounted Cash Flow (DCF) analysis. This calculation is done with the help of the company's financial statement as well as books of accounts in order to understand the worth of the business. The future cash flow of the company is forecasted with DCF analysis which is then discounted to the present value of the firm to get the absolute value.
But it's noteworthy that this approach does not involve any comparison between similar companies in the industry or sector which often becomes a drawback of this model. Another challenge faced in the absolute valuation approach can be forecasting the future cash flow of the business and estimating it correctly.
In the relative valuation approach, the firm¡¯s value is compared with its competitors in the industry to understand its financial worth. Investors may also use this approach to estimate if the stock is worth purchasing or not.?
A number of trading multiples and ratios like price-to-earnings (P/E), free cash flow, Enterprise Value (EV), etc. are applied for calculation under this approach. When compared to the absolute valuation approach, this relative valuation approach uses benchmarks, ratios, and averages in order to estimate the company¡¯s value. The benchmark here could be determined by carrying out a broad industry analysis and calculating an average from it.
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