| Valuation - An Art as well as a Science |
"Pricing an IPO is always a function of the valuation. That’s what is to be determined first," say investment bankers over the world. Estimating a company’s value begins well in advance of the IPO date. Business, planning to go public, typically interviews several investment banking firms before selecting one and the investment bankers, in turn, investigate the company to determine if they want to handle the deal. They perform a detailed review of the company’s finances, the quality of its management team and the company’s position in its major markets. The investment bankers also consider "comparables", which are publicly traded companies in the same industry as the company coming out with an IPO. Selecting right comparables is straightforward when working with established companies in clearly defined or mature industries. It is more challenging to find appropriate benchmarks for younger companies, especially those in new and rapidly changing industries.
Establishing a reasonable value for the company is the critical first step, but the investment bankers must also consider the market’s receptiveness toward IPOs in general and their new issue in particular. You can have the greatest IPO in the world, but if the market is depressed or inflated, you are either penalized or hurt by the environment. Here, the role of investment banker and his importance is to be appreciated. He must balance the conflicting goals of several audiences. The issuer wants the highest price - within reason - for its shares, while investors want to pay the lowest price. Overpricing the issue increases the risk of a poor after-market performance, which can lead to lawsuits from disgruntled investors. Underpricing costs the company substantial sums and can damage the investment banker’s reputation.
In an effort to satisfy all parties, investment bankers traditionally set stock’s offering price 10 percent to 20 percent below its estimated value. This practice, known as "leaving something on the table", serves several purposes. It entices institutional investors to buy the issue because they are getting a bargain, and their participation is usually critical to selling out an issue. Assuming that the stock’s price moves up to its fair value in the after-market, the investors can earn a fast return as a reward for investing in an unseasoned issue. In the long run, the prices of these securities usually come down and trade where they belong. So, even if you have a huge initial pop, investment bankers must live with an IPO over the long run. Also, every buyer doesn’t necessarily sell the issue immediately - you are trying to get long-term investors involved.
All said and done, the process of valuation is a complex one that involves much research and calculations. It is not purely scientific but it is also an art. The most common method of valuation is to look at the valuations of comparable companies. This is accomplished by analyzing price earnings ratios. For this the investment banker will collect data on the EBITD (earnings before interest, tax and depreciation) of the companies in your industry. He will try to focus on those companies that have a similar size, earnings, revenues, profit margins and product mix as your company. Then he will find the price-to-earnings ratio. This P/E ratio of your company is compared with the P/E ratio of the industry to which your company belongs.
Another method of valuation is the discounted cash flow model. This model is based on the concept that the present value of an investment is based on its cash flows. The more money the company makes, the higher the stock price will be, as well as the increased likelihood of dividends. The discounted cash flow model thus requires that you estimate all the future profits of the company. Of course, for a small company, this can be extremely difficult. The model employs a complex calculation, which takes into account the returns on alternative investments and risk (which is called beta). By and large, the P-E ratio method is the most common.
The ultimate pricing of the offering is typically determined the day before the stock is sold. In most cases, the price of the stock will be at a 10 to 20 percent discount to the value. This will create demand in the stock, as people will feel they are getting bargain. For e.g., if you are using the P-E method and the industry standard is 15, then you will probably sell the company to the public at 12 to 13 times the earnings. In some cases there will be frenzy for the stock. In that case the investment banker will adjust the price upwards. As you can see, this process is a matter of knowing what the market sentiment is, which is a subjective matter.
Finally, what really matters is the timing. As the old saying goes: "Timing is everything". This is especially true for IPOs. Markets are highly volatile and susceptible to fads. One year, Media might be hot: the next, Internet stocks are hot. And you will know when this is occurring. You will see articles in magazines, the papers and the news about the stock. If your industry is hot, then you should give serious consideration to going public - doing so, as fast as possible because in six months or so, the mania might be over.
S Suma
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