IPO Valuation

IPO Valuation is definitely one of the complex and excruciating procedures operated in the Indian Stock Market. It involves the use of different financial models by underwriting experts of Investment banks. From an economics point of view, IPO Valuation is a game of demand and supply.

Higher the market demand, the pricing is done in a corresponding way and vice versa.

At the same time, reaching a price point can be a risky affair. If the share price is undervalued then you, as a company, are leaving potential money on the table. On the other hand, if the share price is overpriced, then the business is risking under subscription of their IPO.

Nonetheless, in rest of the article, let’s talk about the different financial models that assist in finalizing the IPO valuation and corresponding share price or range.

Let’s take an example for easier understanding of the concept and the process involved:

For instance, there is a business named PQR Tech and it is looking to launch an IPO in the Indian Stock Market Indices.

Now, like any other business, PQR Tech wants to evaluate itself, monetarily, with the help of external parties such as investment banks and other related financial institutions. During the process of valuation, the hired external parties look at aspects such as Balance sheets, Profit & Loss statements, cash flow statements of the company for the past few years, let’s say 5 years.

At the same time, it is also seen that what the business is looking to achieve in the next few years and what kind of potential revenue (and profit) can be expected out the initiatives the business is looking to take.

In this case, PQR Tech shows a revenue of ₹150 Crore, a profit of ₹43 Crore in the last financial year. This implies that the business is in a positive cash-flow situation.

It also sees whether PQR tech has taken any debts or fundings from any investor or banks since it was incorporated.

Again, in this case, let’s assume that business has taken debts of ₹20 Crore at a stake of 5% from XYZ Investors. This implies that the business valued itself at ₹400 Crore at the time of funding.

Considering all those aspects, these underwriters come down a specific number that is termed as the business valuation. In other words, they finalize the overall business value at that point in time.

Let’s say that the underwriter team valuates PQR Tech at ₹600 Crore.

Now, for this upcoming IPO, the business management sit with the underwriting team (multiple times) to decide what percentage of the stake they are open to giving away for this particular IPO. Depending on the percentage of the stake diluted by different stakeholders, a corresponding number of shares and funding amount are opened in the IPO.

Factors affecting IPO Valuation

Now, although the example of PQR tech mentioned above displays a simpler story, there are zillion other things that happen in the background.

There are specific factors that directly or indirectly impact the price of the share offered and the overall IPO valuation.

Some of those are discussed as follows:

Number of shares opened up for bidding in the IPO

Depending on the total number of shares held by different stakeholders in the company, a specific charting is done. In this charting, the total number of shares opened by these stakeholders and the ones held by the company are summed together. This is also seen that how much of the company owned shares are to be opened up for subscription out of the total.

Future Prospects of the Company

Like mentioned above, the future growth and opportunity potential of the company is quantified as closely as possible. This includes the impact of external factors such as government policies, industry momentum, global variations and so on. With this analysis of growth potential in place, the business and the underwriting team cover the quantified numbers in their IPO statement report (DRHS Document).

Organizational Set-up of the company

The overall hierarchy of the company, that is, the executive management, the chairman, managing directors etc are some of the key people in any business. Some companies intentionally hire some of the industry guns as part of their hierarchy in order to pump up their reputation and credibility, just before the IPO is launched. Thus, make sure to check the duration for which the management has been associated with the company.

Current Market Prices (CMP) of Companies listed from the same Industry

Isn’t it amazing if you get to benchmark a company which is like yours, follows a similar business model and is already listed on the stock market? Thus, comparing your business with other listed companies totally makes sense.  This gives the business looking to file an IPO a direct & relatable idea to the share price proximate to a safe number.

Effectiveness of the Company Business Model

Different companies run different business and revenue models. It is the responsibility of the underwriting team to judge whether the business model of the company is sustainable for a long term. While the team comes to an answer to this question, there are various parameters that come into play. The idea of the complete process is to run through these parameters at both quantitive and qualitative levels.

Market Trend

This is a broad point but certainly, something that needs a lot of pondering. The business team of the company along with the hired underwriters need to analyze the overall share market trend looking at a very generic level. From this broader perspective, the analysis needs to be narrowed down to the specific industry domain. The overall timeline for this trend can be anywhere from the last 12 months to 5 years.

If the business comes from an old-school domain, then the analysis becomes way more interesting when looked from the pre and post 2008 market burst standpoint.

Understanding of the Market Demand

As part of the complete IPO Process, the business and the corporate team of the company goes through road shows across different parts of the country. In these roadshows and business meetings with the potential investors (Institutional investors primarily), the business team gets a reasonable idea about the demand of their upcoming IPO.

Types of IPO Valuation

There are multiple ways in which a business can perform its IPO valuation. This needs to be understood that different valuation methodologies have their own pros and cons and thus, business needs to consider all possible aspects related to the chosen valuation method on their IPO.

Here are the different IPO Valuation types listed:

Economic Valuation

This is pure mathematical valuation where few specific parameters are considered in a hardcore formula. These parameters include the residual income of the business, unpaid debts, the value of assets owned and liabilities to get rid off, investments and so on.

P/E Ratio Methodology

This mathematical technique of business and IPO valuation gives a reasonable level idea. In fact, it actually gives you a number if you have 2 variables handy with you.

Those two variables are P/E Ratio and Annual Net Income. For instance, taking the above-mentioned example of PQR Tech, if they have a P/E Ratio of 10 and their net incomes for the last financial year was ₹150 Crore, then their business value is 10 X ₹150 Crore, i.e. ₹1500 Crore. Finding the IPO Valuation from there is even easier.

Assuming the business is looking to liquidate 20% of the company, then the IPO size will be 20% of ₹1500 Crore, i.e. ₹300 Crore.

Absolute Valuation

This technique requires the business to look at the company fundamentals against the numbers provided as the market value of the company. Now, this technique can be misleading for few businesses as market valuations can sometime be a bubble based on a temporary trend.

Relative Valuation

As the name suggests, IPO Valuation through this technique of relativity requires the team to look at the closest benchmarks in their industry, preferably the companies that are already listed on the stock exchanges. With this way of valuation, the overall judgements are completely objective in nature and throw out any chance of any subjectivity brought in.

Discounted Cash Value Based Valuation

In this technique, the business makes several assumptions in terms of anticipated cash flows, business investments, future business performance, potential revenue streams and so on. Although this requires a lot of groundwork in understanding the business performance so far, all these assumptions made must have a relevant justification.

At the end of the day, this valuation process, irrespective of the chosen technique is an excruciating process and requires a lot of diligence, experience and market understanding. SEBI scrutinizes each and every IPO application from different nooks and corners, to make sure that the money invested by the general investor is going into the right hands, for the right reasons at the right value.

A Quick note for Investors

In case you are looking to invest in an upcoming IPO, do not get blown in the hype created around the IPO. Always remember to look at the company fundamentals, history, read the DRHS document, trends, financial statements, understand the type of IPO it is. Then, run the business details against the points mentioned in this article. Once you are satisfied enough, only then you may choose to apply in IPO.

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