Valuation of hard-to-value equities: Initial Public Offerings (IPOs)

Introduction:

What are IPOs? An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a private company to raise capital from public investors.

What are private corporations? Private companies range from single-employee, unincorporated businesses to formerly public companies that have been taken private in management buyouts or other transactions. The diverse characteristics of private companies have encouraged the development of diverse valuation practices.

To gain an insight to valuation of private companies and IPOs, the difference between a private and public company should be understood. The major difference include:

• Stages in life cycle;
• Size;
• Overlap of shareholders and management;
• Quality and depth of management;
• Quality of financial information;
• Pressure from short-term investors; and
• Tax concerns

From the list we can infer that private companies are disadvantaged as they are listed at the earliest stages of development, their financial statement sizes are lower, top management has a controlling ownership interest and the reduction of reported taxable income and corporate tax payments is an important goal for a private company as opposed to a public company.

Hence, valuing IPOs can be problematic. Prior to the dotcom era, Warren Buffet once said that if he were teaching a finance course, he would ask students to evaluate an internet stock, and any student giving an answer would flunk.

Notably, the problem of IPOs trading below their offer price and/or under-performing with respect to the overall market has led to a loss of investor appetite, which is reflected in the number of companies going public on US exchanges. Also, it is easier to get the public to invest in successful medium or large scale private firm than a startup.

Per research, three anomalies are present in IPO valuations. They include:

• Short-run under-pricing resulting in first-day returns that average 10%–15%;
• Cycles in the volume of new issues and the magnitude of first day returns; and
• Long-run (five-year) under-performance.

In valuing IPOs, there are different valuation basis and methodologies used. IPOs are valued on the basis of P/E, price-to-sales (P/S), enterprise value-to-sales, and enterprise value-to-operating cash flow ratios has some predictive value when used with earnings forecasts and adjusted for differences in growth and profitability. 

Also, the valuation methods include the use of multiples, Discounted Cash Flow (DCF), Dividend Discount Model (DDM), amongst others. All three-valuation methods have similar accuracy, explainability, and (positive) bias with respect to equilibrium market value.

In conclusion, when valuing an IPO, there are essential two-step processes that precede pricing the IPOs. The first step entails having the investment bank perform due diligence and the second step is the “road show,” during which the investment bank tests initial investor sentiment.

Excerpts on my financial advisory presentation made on a CFA publication “Equity Valuation: Science, Art or Craft” 

Many thanks,

Aramide. 💖