IPO PRICE DETERMINATION
The IPO is the path through which growth drives private companies to release their securities to the public to raise capital for the first time. But the question here is how many of us know about how the price is determined in an IPO? You are at the right place as in this article, we are going to discuss this question and gain a deeper understanding of the same. Let’s get started.
TYPES OF IPO ISSUE
Majorly there are 2 types of IPO we can witness in the primary market namely, (i) Book Building IPO Issue and (ii) Fixed Price IPO Issue. An IPO issue can be made available by the company in either of the way or as a mix of both.
Let’s gain a deep knowledge in this regard with a comparison table.
| Comparison | Book Building Issue | Fixed Price Issue |
| Demand | It can be known on a daily basis. | It is known only after the complete closure of the IPO issue. |
| Pricing | The exact stock price is not fixed. Initially a price band is decided. The price is announced and fixed after the last day of the issue/bid. | The share price is predetermined and fixed on the very first day of issue and is printed on the order document. |
| Reservations | 50% of the issue is reserved for the QIBs (Qualified Institutional Buyers), 35% is for small investors and the remaining 15% is for other types. | 50% of the issue is reserved for small investors investing less than Rs 2 lakh capital and the rest is for high value investors. |
| Payment | The payment can be made after the completion of allocation. | The payment needs to be made fully in advance. Refund is given only if the allocation is not made at the end date. |
DETERMINATION OF IPO PRICE
The process of deciding the price for an IPO is a bit complex. Several techniques and methods are applied to determine the IPO price. The 3 most prominent methods are talked about below:
1. Absolute Valuation:
This method is the process to estimate the basic value of the company by analyzing the fundamentals as per the market value. The 2 most popular techniques used for the price calculation are:
2. Discounted cash flow:
It is the NPV of the anticipated cash flows from an investment as at today or at any given point of time. The gross revenue streams are looked upon by using a series of assumptions about the future prospects of business performance and then forecasting how much the revenue the business can generate.
3. Economic Value:
Here, the value is mathematically calculated by accounting the factors which are economical in nature like company’s residual income, assets, outstanding debts and risk bearing potential.
A basic formula is:
Equity Value = (Value of investments and Cash + Enterprise Value) - Value of debts along with other liabilities.
4. Relative Value Method:
This method determines the security price by comparing the fundamentals and financial health of the company in question to similar companies within the same industry. This is why this method is also referred to as comparable valuation. The 2 most popular methods used in reactive revaluation methods are:
1. Value to EBITDA Multiple:
This multiple measures the enterprise value which is the total value of the business operations, in place of measuring the equity value. When the enterprise value is determined and estimated, only the operational value is considered. So, this accounts for the capital value and the security holdings and cash. The investments in treasury bills, bonds or any investments in securities of other companies are excluded. If investors are evaluating any company which has major outstanding debts, it will show adverse earnings but have a positive impact on EBITDA.
2. Price to Earnings Multiple:
It is one of the most used evaluation methods to determine the price of shares, also known as the P/E ratio. This compares a company’s market cap to the annual revenue/income to compute the value of the entity, its estimated value of equity is divided by its recent year’s net income. This method is used when the company has affirmative cash flows and when other peers in the same industry have similar capital and growth structure.
FACTORS INFLUENCING THE VALUATION BEFORE IPO
- The management or organisational set up of the entity.
- The quality of securities currently being sold in an IPO
- Company future growth and revenue prospects
- The current market prices of the stocks of companies in the same industry.
- Financial effectiveness of business model
- The demand from the potential customers for the entity's shares.
- Any positive news about the company like recent achievements, success, acquisition or introducing new product or KMP.
- General overall trend of the stock market.
THE CRUX
It is very significant to know how the IPO price is determined. Share price typically depends on the tangible value of the assets. By using the financial information attached to the prospectus, investors can calculate approx share value to determine whether the IPO shares are priced appropriately or not.
Also Read:
What is Grey Market?
Role of Underwriters in an IPO
How to Invest in IPO
What is Grey Market Premium?