How IPO Pricing Works: A Clear Look at Valuation Methods

The price of shares in an IPO is mainly influenced by supply and demand, which depend on the issuing company’s growth and profitability prospects. Investors need to understand how much a company is valued based on its future potential to make a profitable investment.

This information can be gathered by carefully examining the company’s financial statements. Before launching an IPO, companies must follow Securities and Exchange Board of India (SEBI) guidelines to disclose this data in the IPO prospectus. To learn how to analyse this information and assess whether an IPO is fairly priced, let’s understand how IPOs work and how they are valued.

What Are IPOs and How Do They Work?

An Initial Public Offering, or IPO, is when a private company offers its shares to the public for the first time. After the IPO, the company transitions from private to partly public ownership. Investors, including retail, high-net-worth individuals (HNIs), and institutions, gain ownership by purchasing these shares.

Companies issue IPOs in the primary market to raise funds for expansion, research, and other corporate objectives. Before launching an IPO, they must meet eligibility criteria and file a prospectus with the market regulator. Once approved, the company sets the share price and issue date.

This is also when understanding how IPO allotment works becomes important. Investors place bids on shares, and if their bids are successful, the allotted shares are credited to their demat accounts. Once listed on the secondary market, these shares can be traded, allowing investors the option to sell them for potential profit. This entire process requires careful calculations that consider financial factors, business outlook, management style, and associated risks.

How is an IPO Priced?

There are two primary methods for IPO pricing:

Book Building Offering 

In this method, the merchant banker assigns a price band for the shares based on market trends and allocation needs. This band has a floor and cap price, marking the minimum and maximum bid limits.
For instance, if the price band for a company’s shares is set at ₹100 to ₹120, bids can only be placed within this range. Book-building managers then determine the cut-off price based on the minimum bid needed to allocate all shares. Investors can use a demat app to conveniently participate in IPO bidding within the specified price range.

Fixed Price Offering 

With fixed price offerings, shares are sold at a predetermined price. Investors pay the full price upfront, with demand assessed after the issue session ends. In this model, half the shares are reserved for applications under ₹2 lakh, while the other half is for higher bids. Using a demat app allows investors to quickly access and invest in fixed priced IPOs as well.

How Are IPOs Valued?

Evaluating an Initial Public Offering (IPO) is a complex process that involves extensive calculations and a deep understanding of the market landscape. The primary aim is to ensure that the funds raised through the IPO are justified based on the company’s financial health and growth prospects. The SEBI plays a critical role in this process. It meticulously reviews each IPO application, assessing various aspects of the company’s valuation to protect potential investors from overvalued stocks or companies lacking sound financial fundamentals.  Using a reliable stock market app can further help investors in tracking and analysing IPOs and market trends effectively.

Here are the main methods used in IPO valuation, each with its own unique approach and insights:

Relative Valuation

Relative valuation is a widely used method that involves comparing a company’s financial ratios with those of similar companies within the same industry. This approach helps investors identify whether a stock is overvalued or undervalued based on market comparisons.

Key Ratios 

Investors often look at key financial metrics, such as the Price-to-Earnings (P/E) ratio, Price-to-Sales (P/S) ratio, and Price-to-Book (P/B) ratio. By examining these ratios in the context of peer companies, investors can gauge how the company’s valuation stacks up against its competitors.

Market Sentiment

Relative valuation also considers market sentiment and trends in the industry. A company may be performing well in absolute terms, but if its competitors are outperforming it, the stock may still appear overpriced.

Absolute Valuation

Unlike relative valuation, absolute valuation focuses solely on the company’s own financial statements without comparison to its peers. This method relies on fundamental analysis to assess a company’s intrinsic value.

Financial Metrics 

Absolute valuation involves examining crucial financial metrics such as cash flow, net income, dividends, and growth potential. For instance, a company’s ability to generate consistent cash flow is a strong indicator of its long-term viability.

Future Projections 

Analysts also consider future projections, including expected growth rates and potential market opportunities. This method allows for a more tailored valuation that reflects the unique circumstances and capabilities of the company.

Economic Valuation

Economic valuation takes a more mathematical approach to assess the value of IPO shares. This method evaluates various economic factors that affect a company’s overall worth.

Residual Income 

One key component of economic valuation is the concept of residual income, which measures the profit a company generates after accounting for its cost of capital. This metric helps determine whether the company is creating value for its shareholders.

Liabilities and Assets 

Additionally, analysts look at the company’s liabilities and assets to assess its financial health. Understanding how much debt a company carries compared to its assets is vital for evaluating its risk-bearing capacity.

Discounted Cash Flow (DCF) Valuation

Discounted Cash Flow (DCF) valuation is one of the most comprehensive methods used to evaluate an IPO. This approach calculates the present value of projected future cash flows generated by the company.

Projection of Cash Flows 

The process begins with forecasting future cash flows based on historical performance, market conditions, and expected growth rates. Analysts typically project cash flows over a specific period, often five to ten years.

Discount Rate 

A crucial aspect of DCF valuation is selecting an appropriate discount rate, which reflects the risk associated with the investment. This rate is used to discount future cash flows back to their present value, providing a more accurate valuation.

Sensitivity Analysis 

DCF valuation is sensitive to the assumptions made, meaning that even slight changes in projected cash flows or the discount rate can significantly alter the valuation outcome. Thus, this method requires precision and careful consideration of various factors.

Conclusion

In summary, IPO valuation is not a one-size-fits-all process. Each method offers a different view and can produce different results based on the assumptions used. Understanding these valuation methods is important for investors who want to make smart choices in the IPO market. A thorough evaluation will help you decide if an IPO is a good investment based on its true value and growth potential.

With HDFC SKY, you can open Demat account and invest seamlessly in stocks, mutual funds, and various other financial instruments like derivatives and commodities. HDFC SKY also offers research-based recommendations and expert market insights for intelligent decision-making.