Introduction:
An Initial Public Offering (IPO) helps a privately-owned company transition into a public company and raise equity market capital. When a company decides to go public, it first files a Draft Red Herring Prospectus (DRHP) with the Securities and Exchange Board of India (SEBI) to get approval for the IPO.
Upon approval, the company invites bids from investors and allot shares to them through a lottery. As an investor, you can bid for an IPO within a price range known as the price band. This price band, which the company itself decides, determines IPO valuation. But do you know how an IPO is valued? If not, we will tell you further in this article.
What is IPO valuation?
IPO valuation refers to the price at which the shares are issued to investors. The total money that a company can generate from its IPO depends on the IPO valuation. For example, if a company issues its IPO shares for Rs. 60 per share and sells 10 crore equity shares, it will raise a total of Rs. 600 crore.
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How is an IPO valued?
The issuing company itself does the valuation of an IPO after consultation with investment bankers or underwriters. They assess the demand an IPO can generate based on the issuing company’s financials, assets, liabilities, past performance, and the ability to generate profits in the future. Based on the assessment of these factors, the draft papers are formulated and submitted to the market regulator.
In the draft paper, known as the DRHP, the company mentions the approximate IPO valuation along with other factors, including the last three years’ financials, strengths, risks, objectives of the IPO, etc.
What are the factors that influence IPO valuation?
Below are the factors that are taken into consideration for pre-IPO valuation:
- The issuing company’s financial performance over the last three years
- Number of equity shares being sold by the company
- The issuing company’s growth potential
- The issuing company’s business model
- Prevailing share market trend
- The market price of the shares of similar companies
- Prospective demand for the IPO from potential investors
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Common methods for IPO valuation
Below are the different methods that are used for IPO valuation:
Absolute valuation
The absolute valuation method is used to measure the financial strength of the issuing company. In this method, the experts analyse the Discounted Cash Flow (DCF) to understand how much wealth a company possesses.
Relative valuation
The relative valuation method is used to derive IPO valuation based on the prices of shares of similar companies. In this method, the experts thoroughly analyse the benchmarks in the industry to which an IPO belongs and the share prices of peer companies that have already been listed on the stock exchanges.
Discounted cash-based valuation
The discounted cash-based valuation method considers the issuing company’s ability to perform and generate profits in the future. Experts predict a company’s future growth, investment scope, and potential revenues to determine IPO valuation. This method is the toughest, as it’s never easy to speculate on a company’s future.
Economic valuation
The economic valuation method involves complex mathematical calculations based on the issuing company’s current assets, liabilities, residual income, risks, etc. The different sets of values are used in mathematical formulas to determine various IPO valuation figures. Then, an average of these figures is calculated.
Price-to-earnings multiple valuation
In this method, the IPO valuation is derived by comparing the market capitalisation of the issuing company to its annual income. This method is mainly used when a company has positive cash flows and all other companies in the industry have a similar growth structure.
To conclude
IPO valuation is one of the crucial factors to consider before investing in an IPO. Correct IPO valuation is essential for both the company and the investors. A fairly valued IPO attracts a large number of investors and vice-versa. By knowing how an IPO is valued, you can determine whether a specific IPO is fairly valued or overvalued and hence, make informed investment decisions.
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