How is an IPO Priced: Who Decides the Price of IPO for a Company
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An Initial Public Offering (IPO) is a company listing on one or more stock exchanges, diluting the company's ownership. But who decides the price of the IPO?
During the IPO process, the company's owners decide how many shares they want to offload and appoint a merchant banker to determine the IPO price based on the company's financial reports, business prospects, risks, and management style.
As an investor, subscribing to the company's IPO means acquiring a proportional share of ownership. If allotted shares, investors can take part in the company's profits and losses and receive dividends as part of the company's profitability.
Who Decides the Price of IPO for a Company?
When a company is considering an IPO, it relies on the expertise of merchant bankers to handle all aspects of the process, including preparing documents, filing with the registrar, marketing, issuing shares, evaluating financial statements, and ensuring proper disclosure of material information in the prospectus. One of the most important tasks of merchant bankers is determining the IPO share price. The merchant banker carries out all steps in the IPO process.
Watch this video to understand, How to Apply For An IPO
Methods to Set a Price of an IPO
When considering investing in an IPO, check the value of shares and determine if they are rightly priced. But the question is, who decides the price of an IPO and how? Merchant bankers determine the price of an IPO through two methods: fixed price offering and book building offering.
In a book-building offering, the merchant banker establishes a price range with a floor and cap price, known as a price band. Investors can select their desired price and number of shares at the time of application. In allotment, the company sets the final price, and investors who apply at that price will be allotted shares.
In contrast, the merchant bank sets a specific price in a fixed-price offering. Investors must pay a fixed price to apply for shares.
Determining the appropriate price for an IPO can be complex, and merchant bankers use various methods for IPO valuation, depending on the company's type and available information. These methods include:
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Relative Valuation of an IPO
Merchant bankers are the one who decides the price of an IPO. One of the most common methods merchant bankers use to determine the optimal price is examining the valuations of publicly traded companies. This includes considering factors such as the price-to-earnings ratio, cash flow, and earnings per share. The relative valuation method, also known as the comparative valuation method, involves determining the value of an IPO based on the valuations of other companies. This method requires specialists to compare the IPO to the closest industry benchmarks already listed on stock markets.
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Absolute Valuation of an IPO
An absolute valuation method for an IPO involves analyzing the financial position and strength of the company. Merchant bankers use the discounted cash flow (DCF) method to determine the company's wealth. This approach differs from relative valuation, which compares a company's wealth to its competitors. In contrast, the absolute valuation method evaluates a company's wealth by considering the time value of money and the accumulation of interest.
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Discounted Cash Value-Established Valuation of an IPO
The discounted cash flow (DCF) method values an IPO that assesses projected cash flows, future performance, corporate investments, and potential revenue sources. This method requires a thorough understanding of the company's performance, and all evaluations must be well-justified. An inaccurate estimate can affect the company's valuation, so this method is considered more challenging than relative or comparative valuation methods.
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Economic Valuation of an IPO
The economic valuation of an IPO involves assessing various economic factors of the company to determine the true value of the IPO. Merchant bankers use residual business income, debt status, and the net value of assets owned to determine the true value of the IPO.
Why is IPO Valuation Essential to Look at before Investing in it?
IPO valuation is essential for investors before investing in an IPO as it provides a clear understanding of the factors that merchant bankers consider, who decide the price of the IPO, while valuing the IPO and which aspects are ignored. By understanding which factors are ignored, investors can check whether such factors are relevant to the company's growth or harm the market price in the secondary market after the IPO.
As an investor, evaluating whether a company is underpriced or overpriced is crucial in making investment decisions. Buying overpriced shares can lead to losses, while underpriced shares can be a good opportunity if the company's fundamentals are strong enough to sustain and grow. The IPO valuation process helps investors identify the company's true value, which is essential for investors to make informed investment decisions.
Components of IPO Valuation
The valuation of an IPO is dependent on various factors, including consumer demand for the company's shares, industry comparables, growth prospects, and the company's story. High demand for a company's shares leads to a higher stock price. These components are crucial for determining the true value of an IPO and help investors make informed investment decisions.
The demand for a company's shares does not state its actual value but affects its valuation. IPO valuation determines the fair value of a company's shares. Two identical companies may have different valuations based on the timing of the IPO and market demand. Companies go public when they determine high demand for their shares.
For example, in 2000, many technology companies had high IPO valuations during the technology bubble. Compared to companies that got public later, they received higher valuations and more investment capital. This was due to the trend of technology stocks and the high demand in early 2000 rather than a reflection of the actual superiority of these companies.
In IPO valuation, industry comparables are used to compare the valuation multiples of the IPO candidate to those of publicly-traded companies in the same field. This is done to determine a fair value for the new entrant, as investors are likely to pay a similar amount for it as they do for existing companies in the industry.
The value assigned to a company during an IPO is based on the projected growth of the company. As the main goal of an IPO is to raise funds for expansion, the company's ability to grow is a crucial factor in determining its value. The success of an IPO is often linked to the credibility of the company's growth projections.
The market conditions also play a role in the pre-IPO valuation. Economic downturns or recessions can lower the valuation of the company.
A company's management team's experience and track record can influence pre-IPO valuation. Investors will look at the team's ability to lead the company and drive growth in the future.
An IPO valuation is not only based on quantitative factors but also on qualitative ones, such as the company's story and potential to revolutionize an industry. For example, companies that pioneered the Internet in the 1990s were given high valuations despite not having any revenue due to the perceived potential of their new and innovative technologies.
Yet, it is important to note that a company's corporate narrative and marketing campaign can sometimes be overstated. Investors should review a company's financials and be aware of the risks of investing in a company with no established trading history. Companies may enhance their corporate narrative by hiring industry veterans or consultants to give the appearance of a growing business with experienced management.
The industry's competitive landscape also plays a role in determining the pre-IPO valuation. If the company operates in a competitive environment, it may be valued lower than companies in less competitive industries.
Why is It Important for an Investor to Understand the Process of IPO Valuation?
Investors need to understand the process of IPO valuation because it helps them make informed investment decisions. Companies hire investment banks to underwrite securities and set the offer price, who decides the price of the IPO, which may not always reflect the company's true value.
By understanding how an IPO is valued, investors can use information such as the company's balance sheet and past performance to determine the true value of the offered shares. By keeping up to date with upcoming IPO news and researching the company, investors can better understand the company's potential and the risks involved in investing in an IPO.
Offer Price vs Opening Price
When a company goes public through an initial public offering (IPO), the offer price and the opening price are two important terms that investors need to understand. The offer price is the price at which shares are offered to the public during the IPO process, while the opening price is when the shares begin trading on the stock exchange on the first day of trading.
The company, underwriters, and investment banks set the offer price. It is based on factors such as the company's financials, industry comparables, and market conditions. The offer price is usually disclosed in the prospectus and is the price that investors are required to pay when they apply for shares during the IPO.
The opening price is determined by supply and demand in the market. It is usually determined by the market makers and the exchanges and can fluctuate based on trading activity. The opening price can be higher or lower than the offer price.
If the opening price is higher than the offer price, it indicates strong demand for the shares during the IPO process, and the shares were oversubscribed. This is a positive sign for the company and its shares and may lead to a future share price increase.
If the opening price is lower than the offer price, it indicates weak demand for the shares during the IPO process, and the shares are undersubscribed. This can be seen as a negative sign for the company and its shares and may lead to a future share price decrease.
Bottomline
Pricing an IPO is a complex process considering many factors, such as the company's financials, industry comparables, and market conditions. The company, underwriters, and investment banks work together to determine the offer price of an IPO, which is the price at which shares are offered to the public. The opening price is determined by supply and demand in the market and can fluctuate based on trading activity. By understanding the factors that influence the pricing of an IPO, investors can make more informed decisions and determine the true value of the shares being offered.
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Frequently Asked Questions
- Who determines the price of an IPO?
- The company, underwriters, and investment banks work together to determine the price of an IPO.
- Is an IPO price always reflective of the company's true value?
- Not necessarily, as the underwriters and investment banks may have their interests in setting the price.
- How is the value of a company determined during an initial public offering?
- The value of a company during an IPO is determined by evaluating financials, past performance, and future growth prospects and comparing it with similar companies in the industry.
- How does book building affect the pricing of an IPO?
- Book building is a process where the demand for shares is gauged, and the price is determined based on that demand.
- Can the price of an IPO change after it is launched?
- Yes, the price can fluctuate based on market conditions and investor demand.
- What are the risks of investing in an underpriced or overpriced IPO?
- Underpriced IPOs may not raise enough capital for the company, while overpriced IPOs may not attract investors.
- How do you determine if an IPO is priced correctly?
- By evaluating the company's financials, past performance, and future growth prospects and comparing it with similar companies in the industry.
- How do you know when an IPO is coming out?
- You can refer to the IPO calendar and look for upcoming IPO news to know about the new entrants to the stock market.
- What is the cut-off price for an IPO?
- The cut-off price in an IPO is the final price of the shares determined after the book-building process and the final price of shares sold to investors. In an IPO, the cut-off price is generally between the floor price and the cap price set during the book-building process.
- Who loses when the value of shares in an IPO is too low or underpriced?
- When the value of shares in an IPO is set too low, the company that is going public loses money, as it could have raised more capital if the shares were priced higher. It also results in the dilution of ownership for the existing shareholders. Underwriters and investment banks also make money in such cases but at the cost of the issuer and the investors who applied for the shares at a discounted price.