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There have been at least a dozen mainstream IPO (Initial Public Offering) launches per year for the past five years. And, in an economy like India, one of the fastest-growing major economies in the world, we do not expect a slowdown in this trend. Private companies will continue launching their IPOs to be listed on stock exchanges like the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). Many investors, too, are eager to invest in the IPO and become the first retail shareholders of the company. That is because there are some substantial and innovative businesses in India, and many IPOs have created enormous wealth for their investors. Some IPOs released in the past couple of years have already doubled or tripled in value.
However, many companies have taken advantage of this IPO trend and are launching their IPOs at excessive valuations. Investing in an overvalued IPO may make you money in the short term, but the price is likely to correct eventually. The valuation of an IPO is a vital aspect an investor should understand before investing in it. However, as investors, we should know how IPOs are valued in the first place. That will help answer the question, ‘How is the final IPO price determined?’
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What Does an IPO Valuation Mean for Investors?
Let us go through a more elaborate reason why, as an investor, you should know how a company’s IPO is valued. When you understand how the IPO is valued, you will have a clearer picture of the company’s business potential. At the same time, it also helps you see through the hype around the IPO created by marketing and advertising campaigns. By evaluating the company’s financial statements, you will be able to distinguish overvalued IPOs from fairly valued ones.
Factors that Determine How an IPO Is Valued
Several factors or components decide the valuation of an IPO. These factors include the company’s past financial performance, industry peers, growth potential, and overall picture of the industry. The company hires investment bankers who thoroughly assess the above factors and determine a price range for the IPO. As investors, we, too, must analyse those factors to see if the price band is justified. Let us study each of those four factors in detail below.
Financial Performance
The company’s past financial performance has a significant role in deciding its valuation. Investors are more likely to pay a high valuation if the company’s past financial performance was strong and its sales and profits grew rapidly. Conversely, investors may avoid investing in the IPOs of those businesses where the revenues and earnings are lumpy. However, past business performance only ensures robust performance in the future. Hence, it is essential to look beyond the financial numbers.
Potential Growth
The IPO will only be successful if the company continues to scale up its revenue and earnings growth. In the case of loss-making companies, you have to see if the company can have a successful turnaround and turn profitable. Regardless, in both cases, you must understand the company’s business. Only if you know the company’s business will you be able to analyse its future revenue and profitability. So, study the industry to identify prospective triggers that can generate revenue and profits.
Industry Peers
Another factor investors scrutinise is the valuations of the company’s competitors that are already trading publicly. For example, if an IT company plans to come out with its IPO tomorrow, investors will compare the company’s valuation to that of listed IT companies like TCS, Infosys, and HCL Technologies. So, investors can decide if the IPO is overvalued depending on how it is valued compared to its competitors. However, as an investor, you must always remember that it’s never an apples-to-apples comparison, as every company’s traits distinguish it from its peers.
Larger Industry Picture
The industry’s overall developments and prospects also play a role in determining the company’s valuation. For example, since the Covid-19 pandemic, companies consider cyber security expenses paramount. Investors may be willing to pay higher valuations for companies specialising in cyber security compared to regular IT companies.
Methods of IPO Valuation
Financial experts and investment bankers account for the above factors and then determine the IPO’s valuation. They use the methods mentioned below for this purpose. As a retail investor, you can also adopt the same methods to estimate and assess the valuation of the IPO.
Relative Valuation
In this method, the investor or professional refers to the valuation of already-listed companies catering to the same industry and decides the best price based on that. This method also accounts for factors such as the company’s price-to-earnings (P/E) ratio, earnings per share, and cash flow.
Absolute Valuation
The absolute valuation method is much more technical and complex than the previous valuation method. This method may be too confusing for a beginner; however, if you are willing to learn, you can calculate it. In this method, a team of professionals estimates the company’s future revenues and cash flows and calculates its intrinsic value using the discounted cash flow (DCF) method. The discounted cash flow method is one of the most reliable methods to assess the company’s financial condition and find its accurate valuation.
Economic Valuation
In this method used to perform a valuation of IPOs, investors evaluate the company based on many different parameters. These parameters include the company’s debt, the value of its total assets, its liabilities, the capital intensity of the business, etc.
Conclusion
So, that answers ‘how the final IPO price is determined’. At the same time, you now also know what strategies you can adapt to evaluate the valuation of an IPO. One of the keys to generating wealth in the stock market is to buy stocks at a fair valuation, regardless of whether it is an IPO or a stock trading on the secondary market. Suppose you look at some of the popular new-age companies like Paytm and Policy Bazaar that released their IPOs at exorbitant valuations and that, as of December 2022, were trading way below their initial IPO price. So, despite their popularity and significant IPO, they failed to generate wealth for their IPO due to their high valuations.