Question

Regarding an IPO, what are different cost factors and how can those be measured?

Answer 1

Factors Affecting the Stock Value Price of a New IPO. The procedure of offering the shares of the private company to the public itself for the first time is known as the IPO(Initial Public Offering). The growing organizations that are in requirements of the funds use the IPO for raising the money.

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 company to raise capital from public investors. The transition from a private to a public company can be an important time for private investors to fully realize gains from their investment as it typically includes share premiums for current private investors. Meanwhile, it also allows public investors to participate in the offering.

A company planning an IPO will typically select an underwriter or underwriters. They will also choose an exchange in which the shares will be issued and subsequently traded publicly.

The term initial public offering (IPO) has been a buzzword on Wall Street and among investors for decades. The Dutch are credited with conducting the first modern IPO by offering shares of the Dutch East India Company to the general public. Since then, IPOs have been used as a way for companies to raise capital from public investors through the issuance of public share ownership. Through the years, IPOs have been known for uptrends and downtrends in issuance. Individual sectors also experience uptrends and downtrends in issuance due to innovation and various other economic factors. Tech IPOs multiplied at the height of the dot-com boom as startups without revenues rushed to list themselves on the stock market. The 2008 financial crisis resulted in a year with the least number of IPOs. After the recession following the 2008 financial crisis, IPOs ground to a halt, and for some years after, new listings were rare. More recently, much of the IPO buzz has moved to a focus on the so-called unicorns—startup companies that have reached private valuations of more than $1 billion.

Understanding an IPO

Prior to an IPO, a company is considered private. As a private company, the business has grown with a relatively small number of shareholders including early investors like the founders, family, and friends along with professional investors such as venture capitalists or angel investors.

When a company reaches a stage in its growth process where it believes it is mature enough for the rigors of SEC regulations along with the benefits and responsibilities to public shareholders it will begin to advertise its interest in going public. Typically, this stage of growth will occur when a company has reached a private valuation of approximately $1 billion, also known as unicorn status. However, private companies at various valuations with strong fundamentals and proven profitability potential can also qualify for an IPO, depending on the market competition and their ability to meet listing requirements.

An IPO is a big step for a company. It provides the company with access to raising a lot of money. This gives the company a greater ability to grow and expand. The increased transparency and share listing credibility can also be a factor in helping it obtain better terms when seeking borrowed funds as well.

IPO shares of a company are priced through underwriting due diligence. When a company goes public, the previously owned private share ownership converts to public ownership and the existing private shareholders’ shares become worth the public trading price. Share underwriting can also include special provisions for private to public share ownership. Generally, the transition from private to public is a key time for private investors to cash in and earn the returns they were expecting. Private shareholders may hold onto their shares in the public market or sell a portion or all of them for gains.

Meanwhile, the public market opens up a huge opportunity for millions of investors to buy shares in the company and contribute capital to a company’s shareholders' equity. The public consists of any individual or institutional investor who is interested in investing in the company. Overall, the number of shares the company sells and the price for which shares sell are the generating factors for the company’s new shareholders' equity value. Shareholders' equity still represents shares owned by investors when it is both private and public, but with an IPO the shareholders' equity increases significantly with cash from the primary issuance.

Largest IPOs

• Alibaba Group (BABA) in 2014 raising $25 billion
• American Insurance Group (AIG) in 2006 raising $20.5 billion
• VISA (V) in 2008 raising $19.7 billion
• General Motors (GM) in 2010 raising $18.15 billion
• Facebook (FB) in 2012 raising $16.01 billion

Underwriters and the IPO Process

An IPO comprehensively consists of two parts. The first is the pre-marketing phase of the offering, while the second is the initial public offering itself. When a company is interested in an IPO, it will advertise to underwriters by soliciting private bids or it can also make a public statement to generate interest. The underwriters lead the IPO process and are chosen by the company. A company may choose one or several underwriters to manage different parts of the IPO process collaboratively. The underwriters are involved in every aspect of the IPO due diligence, document preparation, filing, marketing, and issuance.

Steps to an IPO include the following:

1. Underwriters present proposals and valuations discussing their services, the best type of security to issue, offering price, amount of shares, and estimated time frame for the market offering.
2. The company chooses its underwriters and formally agrees to underwriting terms through an underwriting agreement.
3. IPO teams are formed comprising underwriters, lawyers, certified public accountants, and Securities and Exchange Commission experts.
4. Information regarding the company is compiled for required IPO documentation.
   a. The S-1 Registration Statement is the primary IPO filing document. It has two parts: The prospectus and privately held filing information. The S-1 includes preliminary information about the expected date of the filing. It will be revised often throughout the pre-IPO process. The included prospectus is also revised continuously.
5. Marketing materials are created for pre-marketing of the new stock issuance.
   a. Underwriters and executives market the share issuance to estimate demand and establish a final offering price. Underwriters can make revisions to their financial analysis throughout the marketing process. This can include changing the IPO price or issuance date as they see fit.
   b. Companies take the necessary steps to meet specific public share offering requirements. Companies must adhere to both exchange listing requirements and SEC requirements for public companies.

1. Form a board of directors.
2. Ensure processes for reporting auditable financial and accounting information every quarter.
3. The company issues its shares on an IPO date.
   a. Capital from the primary issuance to shareholders is received as cash and recorded as stockholders' equity on the balance sheet. Subsequently, the balance sheet share value becomes dependent on the company’s stockholders' equity per share valuation comprehensively.
4. Some post-IPO provisions may be instituted.
   a. Underwriters may have a specified time frame to buy an additional amount of shares after the initial public offering date.
   b. Certain investors may be subject to quiet periods.

KEY TAKEAWAYS

• An initial public offering refers to the process of offering shares of a private corporation to the public in a new stock issuance.
• Companies must meet requirements by exchanges and the SEC to hold an initial public offering.
• IPOs provide companies with an opportunity to obtain capital by offering shares through the primary market.
• Companies hire investment banks to market, gauge demand, set the IPO price and date, and more.
• An IPO can be seen as an exit strategy for the company’s founders and early investors, realizing the full profit from their private investment.

Corporate Finance Advantages

The primary objective of an IPO is to raise capital for a business. It can also come with other advantages.

• The company gets access to investment from the entire investing public to raise capital.
• Facilitates easier acquisition deals (share conversions). Can also be easier to establish the value of an acquisition target if it has publicly listed shares.
• Increased transparency that comes with required quarterly reporting can usually help a company receive more favorable credit borrowing terms than as a private company.
• A public company can raise additional funds in the future through secondary offerings because it already has access to the public markets through the IPO.
• Public companies can attract and retain better management and skilled employees through liquid stock equity participation (e.g. ESOPs). Many companies will compensate executives or other employees through stock compensation at the IPO.
• IPOs can give a company a lower cost of capital for both equity and debt.
• Increase the company’s exposure, prestige, and public image, which can help the company’s sales and profits.

IPO Disadvantages and Alternatives

Companies may confront several disadvantages to going public and potentially choose alternative strategies. Some of the major disadvantages include the following:

• An IPO is expensive, and the costs of maintaining a public company are ongoing and usually unrelated to the other costs of doing business.
• The company becomes required to disclose financial, accounting, tax, and other business information. During these disclosures, it may have to publicly reveal secrets and business methods that could help competitors.
• Significant legal, accounting, and marketing costs arise, many of which are ongoing.
• Increased time, effort, and attention required of management for reporting.
• The risk that required funding will not be raised if the market does not accept the IPO price.
• There is a loss of control and stronger agency problems due to new shareholders who obtain voting rights and can effectively control company decisions via the board of directors.
• There is an increased risk of legal or regulatory issues, such as private securities class action lawsuits and shareholder actions.
• Fluctuations in a company's share price can be a distraction for management which may be compensated and evaluated based on stock performance rather than real financial results.

• Strategies used to inflate the value of a public company's shares, such as using excessive debt to buy back stock, can increase the risk and instability in the firm.
• Rigid leadership and governance by the board of directors can make it more difficult to retain good managers willing to take risks.

Having public shares available requires significant effort, expenses, and risks that a company may decide not to take. Remaining private is always an option. Instead of going public, companies may also solicit bids for a buyout. Additionally, there can be some alternatives that companies may explore.

Direct Listing

A direct listing is when an IPO is conducted without any underwriters. Direct listings skip the underwriting process, which means the issuer has more risk if the offering does not do well, but issuers also may benefit from a higher share price. A direct offering is usually only feasible for a company with a well-known brand and an attractive business.

Dutch Auction

In a Dutch auction, an IPO price is not set. Potential buyers are able to bid for the shares they want and the price they are willing to pay. The bidders who were willing to pay the highest price are then allocated the shares available. In 2004, Alphabet (GOOG) conducted its IPO through a Dutch auction. Other companies like Interactive Brokers Group (IBKR), Morningstar (MORN), and The Boston Beer Company (SAM) also conducted Dutch auctions for their shares rather than a traditional IPO.

Investing in IPOs

When a company decides to raise money via an IPO it is only after careful consideration and analysis that this particular exit strategy will maximize the returns of early investors and raise the most capital for the business. Therefore, when the IPO decision is reached, the prospects for future growth are likely to be high, and many public investors will line up to get their hands on some shares for the first time. IPOs are usually discounted to ensure sales, which makes them even more attractive, especially when they generate a lot of buyers from the primary issuance.

Initially, the price of the IPO is usually set by the underwriters through their pre-marketing process. At its core, the IPO price is based on the valuation of the company using fundamental techniques. The most common technique used is discounted cash flow, which is the net present value of the company’s expected future cash flows. Underwriters and interested investors look at this value on a per share basis. Other methods that may be used for setting the price include equity value, enterprise value, comparable firm adjustments, and more. The underwriters do factor in demand but they also typically discount the price to ensure success on the IPO day.

It can be quite hard to analyze the fundamentals and technicals of an IPO issuance. Investors will watch news headlines but the main source for information should be the prospectus, which is available as soon as the company files its S-1 Registration. The prospectus provides a lot of useful information. Investors should pay special attention to the management team and their commentary as well as the quality of the underwriters and the specifics of the deal. Successful IPOs will typically be supported by big investment banks that have the ability to promote a new issue well.

Overall, the road to an IPO is a very long one. As such, public investors building interest can follow developing headlines and other information along the way to help supplement their assessment of the best and potential offering price. The pre-marketing process typically includes demand from large private accredited investors and institutional investors which heavily influence the IPO’s trading on its opening day. Investors in the public don’t become involved until the final offering day. All investors can participate but individual investors specifically must have trading access in place. The most common way for an individual investor to get shares is to have an account with a brokerage platform that itself has received an allocation and wishes to share it with its clients.

Performance

There are several factors that may affect the return from an IPO which is often closely watched by investors. Some IPOs may be overly hyped by investment banks which can lead to initial losses. However, the majority of IPOs are known for gaining in short-term trading as they become introduced to the public. There are a few key considerations for IPO performance.

Lock-Up

If you look at the charts following many IPOs, you'll notice that after a few months the stock takes a steep downturn. This is often because of the expiration of the lock-up period. When a company goes public, the underwriters make company insiders such as officials and employees sign a lock-up agreement. Lock-up agreements are legally binding contracts between the underwriters and insiders of the company, prohibiting them from selling any shares of stock for a specified period of time. The period can range anywhere from three to 24 months. Ninety days is the minimum period stated under Rule 144 (SEC law) but the lock-up specified by the underwriters can last much longer. The problem is, when lockups expire, all the insiders are permitted to sell their stock. The result is a rush of people trying to sell their stock to realize their profit. This excess supply can put severe downward pressure on the stock price.

Waiting Periods

Some investment banks include waiting periods in their offering terms. This sets aside some shares for purchase after a specific period of time. The price may increase if this allocation is bought by the underwriters and decrease if not.

Flipping

Flipping is the practice of reselling an IPO stock in the first few days to earn a quick profit. It is common when the stock is discounted and soars on its first day of trading.

Tracking Stocks

Closely related to a traditional IPO is when an existing company spins off a part of the business as its own standalone entity, creating tracking stocks. The rationale behind spin-offs and the creation of tracking stocks is that in some cases individual divisions of a company can be worth more separately than as a whole. For example, if a division has high growth potential but large current losses within an otherwise slowly growing company, it may be worthwhile to carve it out and keep the parent company as a large shareholder then let it raise additional capital from an IPO.

From an investor’s perspective, these can be interesting IPO opportunities. In general, a spinout of an existing company provides investors with a lot of information about the parent company and its stake in the divesting company. More information available for potential investors is usually better than less and so savvy investors may find good opportunities from this type of scenario. Spinouts can usually experience less initial volatility because investors have more awareness.

IPOs Long-Term

IPOs are known for having volatile opening day returns that can attract investors looking to benefit from the discounts involved. Over the long-term, an IPO's price will settle into a steady value which can be followed by traditional stock price metrics like moving averages. Investors who like the IPO opportunity but may not want to take the individual stock risk may look into managed funds focused on IPO universes. There are a few IPO index funds that can also be a good investment such as the First Trust U.S. Equity Opportunities ETF (FPX).

#1 – Public Value:

The investors and the entities which are interested in buying an IPO have a deep sense on the amount that they are actually willing to pay for the initial public offering of a company. Sometimes this price doesn’t come at par with the cost that the organization is asking for as the company insiders as well as the investing public both possess a different kind of information to base the value on it. When people think that a particular IPO is overpriced and do not show interest in investing in it, then due to the wide difference between the supply and demand, the value of the stock will decline sharply. When people scramble for buying the new offerings, then the demand could lead to an increase in the price.

#2 – Scrutiny

When an organization goes public then, there would be higher of the pervasive scrutiny. So when an organization opens up to the public investment, then the operations of the firm would actually be considered as the business of the people itself. This will have a dramatic influence on the stock value. For example, the financial strain due to the hiring of the additional legal professionals accounts personnel for records keeping can have a stronger influence.

#3 – Lock up:

There is also a lock-up period after the IPO initial public offering when the investors, as well as the company insiders, are actually not allowed to sell out their stocks. This is being done for the prevention of the insiders from waiting for the people to invest and later cash it on at the expense of the investors. Since the lock-up period is generally six months long therefore the sales can be affected. The investors might want to cash it on the shares which can push the price down or there might be an instance that the investors try to hold the shares which will accelerate the prices.

Also Read: Future IPO Initial Public Offering Opportunities and Challenges In India

#4 – Future Prospects:

The organization might look for the short-term gains for producing the top class quarterly results for the capital markets as well as the shareholders. The extra of the debts which have financed the new of the acquisitions can have a negative and short-term affects on the value of the stocks. But even without this particular type of investment, the organization might not be able to achieve the long-term goals.

#5 – Growth and Expansion:

The growth and expansion can be one of the main reasons for an organization to go public, increase liquidity and gain access to the funds. The company should be clear about its vision. Then there is no reason that the IPO stock market will not have a positive growth. Although there is no sure shot guarantee that the stock prices will rise and fall with the success as well as the fortune of the firm but there is actually a strong correlation between the two. The company which has strong fundamentals and clear-cut expansion plan may likely see quite a significant acceleration in the stock prices.

The price of an IPO is decided by the supply and demand of the trade market. Usually, they are sold at the price at which the buyer would like to buy. Doesn’t it sound too simple? In reality, the process of valuation isn’t that easy. If an IPO is underpriced, then a chance of pocketing the gains after the listing is for a long period. On the other hand, if it is overpriced, post listing you won’t get much gain. Any keen follower of latest IPO news would have clearly observed this in the performances

The stock prices of different businesses are valuated using different techniques such as:

• Factors which influence the pre-IPO valuation
• Absolute valuation
• Relative valuation

Factors which influence the pre-IPO valuation

The company and its underwriters work together to come up with a share price. Factors which influence pricing are,

• The quantity of stocks being sold in an IPO

• The organizational set-up of the private company

• The current prices of the stocks of similar companies in the same sector

• Company’s growth potential

• Company’s business model financial effectiveness

• General overall market trend

• The demand from the potential customers for company’s stock

Sometimes, the company’s success story, the values they believe in, products they offer may also affect pricing.

Absolute valuation

Absolute valuation is when the company’s basic value is estimated against the market value using the company’s fundamentals. By using these techniques they arrive at per share value.

Discounted cash flow:

It is the net current value of the anticipated cash flows from an investment as at today or on any given time. The revenue streams are projected by using a series of assumptions about how the future business performance and then forecasting how this business performance translates into the revenue stream generated by the business.

Economic value:

The value is arrived mathematically by considering the Company’s residual income, assets, the risk bearing potential, debts to be paid off and such economic factors.

Value of equity = Enterprise value + Value of cash and investments – Value of debt and other liabilities

Relative valuation

Relative valuation works by comparing the company in question to similar companies in the same business. That is why it is also called comparable valuation.

Price to Earning Multiple:

One of the most common valuation method used is Price-to-Earning multiples. This compares a company’s market cap to its annual income. To determine the value of the company, its estimated equity value is divided by its recent net income to find out the price-to-earnings multiple. This method is used when the company has positive cash flows and when the companies in the same sector have similar growth and capital structure.

Value to EBITDA multiple:

This multiple, measures the value of business operations which is the enterprise value, instead of the value of the equity. When the enterprise value is calculated, only the operational value of the business is considered. So, it accounts for the capital value and cash and security holdings. The investment in treasury bills or bonds, or investment in stocks of other companies, is excluded. When you are evaluating the companies which have huge debts to pay off, they will have negative earnings but a positive EBITDA value.

Why is it important for an investor to know how IPO is valued?

To value an IPO, a business hires an investment bank to underwrite the securities. They are paid to make the offer price look lucrative. They certify that the price accounts every relevant inside information of the past performance and the future payoffs.

Stock share value is usually based on the tangible value of the underlying assets. By using the balance-sheet information enclosed in the prospectus, potential investors can compute an accurate share value to help establish whether the market has correctly priced the IPO shares.

The objective of an IPO is to sell a pre-determined number of shares at the best possible price. Very few IPOs come to market when the appetite for stocks is low. ... So, before investing in any IPO, understand that investment bankers promote them during times when the demand for stocks is favorable.

An IPO can typically be a fixed price issue or a book built issue. In a book built issue, the price band is determined, but the actual issue price is discovered during the IPO. Since Indian IPOs are predominantly through the book built route, we shall focus on the indicative pricing of the book built issues.

Factors impacting the price of an IPO
The following factors are the key to the pricing of an Initial Public offering:

• Financial performance of the company over the last 3 years on a quarterly basis
• Projected growth in revenues and profits suitably ratified by channel checks
• Unique nature of the product and the moat that the company has been able to create
• Comparative valuation of companies in the similar industry group
• Qualitative factors such as management pedigree, brands, and corporate governance.

Absolute vs. relative approach to IPO valuations
The first step to determining the indicative price of a book built issue is the combination of absolute and relative parameters.

Absolute approach to IPO valuation
In case of profit making companies, the focus is on discounting the cash flows of the future. Typically, the future cash flows of the company are projected, and then an appropriate discounting of these factors is done to arrive at the present value. But, what about companies that are not making profits? This is quite common in case of companies that have long gestation periods or where the business involves higher initial outlays such as ecommerce and pharma. In such cases, the Enterprise Value is measured as a percentage of EBITDA to arrive at an indicative valuation parameter.

Relative approach to IPO valuation
Stock valuations and IPO valuations are never done in absolute terms but in relative terms. For example, even with robust cash flows, companies dealing in commodities attract lower valuations due to the cyclical nature of their business. Hence, such commodity companies attract lower valuations (P/E) compared to brands. Typically, relative valuations use parameters such as P/E, P/BV, Dividend Yield, and EV/EBITDA. Normally, once the absolute valuations are arrived at, the relative valuations are considered based on the peer group comparisons and overall market P/E benchmarks.

Finally, it is all about demand and appetite

• Even after considering the quantitative and qualitative factors, the process of IPO pricing is far from complete. Some more critical inputs are considered before the final indicative price range for book building is arrived.
• Pricing of the IPO depends on the stage of the IPO cycle. In the early stages, the valuations tend to be muted but get more aggressive over time. In the early stages, promoters and investment bankers try to leave more on the table for investors.
• What is the state of the market at the time of the IPO? Markets may go into a temporary or permanent bear phase by the time the issue is opened. In such cases, the promoters and investment bankers may take a conscious call to tone down valuations.
• Are there any sectoral last mile issues? NBFCs planning IPOs at this point may have to settle for lower valuations considering that the sector is currently facing a crisis of liquidity and asset-liability mismatch.
• Feedback coming from institutional roadshows is also a critical input. Normally, the institutional appetite is clear only when the management meets the FPIs and Mutual Funds across geographies.
• Retail feedback from brokers, sub-brokers, and distributors is a key input in the final pricing.

It is the aggregation of all these factors that results in the indicative price of the Book Built IPO.

he IPO market is beginning to show signs of recovery. While uncertainty hangs over equity markets as a whole, many analysts are taking encouragement from post-IPO pricing well above the initial list. Some anticipate a surge in IPOs as companies proceed with offerings postponed from 2001.

As the market recovers, one common indicator of success that many IPO watchers continue to apply is the increase in share price on the first day of trading. During the 1990s IPO boom, some considered a two-digit increase to be the measure of IPO success. Others drew a benchmark from so-called daily doublers, or IPOs that doubled their share price on day one. True, an argument can be made that some measure of underpricing is appropriate compensation for first-round investors who face levels of risk that they would not face for secondary offerings.¹ But even then, from the perspective of issuing shareholders, an excessive first-day jump should be viewed as a measure of the mispricing and failure of an IPO, rather than as a measure of its success.

No question, extremes such as Theglobe.com’s November 1998 IPO, with first day returns over 300 percent, helped to firmly establish an industry norm of significant IPO underpricing—offering shares at prices far below the expected first-day closing price. On average, IPOs were underpriced by only 11 percent between 1990 and 1998, but that gap soared to almost 70 percent during 1999 and 2000. Indeed, the enormous jumps of the 1990s have even sparked regulators to scrutinize numerous deals. Whether driven by capital market inefficiencies or inappropriate pricing, the fact is that issuing shareholders probably got short shrift. In 1999 and 2000 alone corporate America left more than $60 billion on the table²—money that could have been invested in the development of the newly listed companies.

How should IPO success be measured? To answer that question we examined 230 IPOs around the world between 1991 and 2000, ranging from $50 million to $18 billion. We included a broad selection of IPO situations: new dot-com companies, established private companies and family-owned businesses, and spin-offs of larger corporations or state-owned companies. Within this range we sought common measures of IPO success across business sectors, economic cycles, and sources of offered assets in strong and weak markets. We analyzed financial data and detailed offer prospectus information, and conducted interviews to clarify and interpret the results.

While there are obviously large differences in the number and types of activities involved for the myriad of IPO situations, we developed a new, practical way to measure an IPO’s success that eschews the goal of a huge first-day leap in share price. We view it as a more valuable metric because it takes into account a company’s longer-term competitiveness and the degree to which both new and existing shareholders are fairly compensated.

Our metric comprises two parts:

1. Market Competitiveness: relative company value equal to or higher than industry peers.

Within 30 days of the IPO, the company’s market capitalization should be at or above the level of its industry peers. For companies in banking and financial services, for example, relative company value may be measured as market-to-book value of equity. For industrial companies, multiples such as market value of equity over earnings, entity value over EBITDA³ or cash flow may be more appropriate. This relative value expresses a company’s competitiveness in the capital markets. Investors can thus use it as a guide to better understand a company’s continuing ability to attract funding.

Using this measure, 50 percent of the IPOs from the 1990s considered highly successful by the first-day jump measure (i.e., greater than 20 percent jump) would actually have been judged to have been failures. By contrast, 74 percent of the companies that proved strong relative to competitors after 30 days had less than a 20 percent first-day jump.

2. Market Pricing: Less than 20 percent change between offering price and 30-day post-IPO market capitalization.

Only an offering price that reflects the market value of the assets sold ensures that both new and issuing shareholders are fairly compensated. Market value should be measured 30 days after an IPO to allow the market time to fairly evaluate the assets on offer. Once again, using this measurement many IPOs considered successful during the 1990s generally appear to have been unfairly priced. Large first-day jumps translate into significant price changes over the first 30 days of trading and are thus a significant and inappropriate transfer of value to subscribers. Only a quarter of IPOs with first-day jumps exceeding 20 percent eventually settled within 100 percent to 120 percent of their IPO price 30 days later. Conversely, only 14 percent of IPOs that did settle within 100 percent to 120 percent of their IPO price after 30 days had seen a first-day jump exceeding 20 percent.

In fact, only 8 percent of all the IPOs we measured were both competitive in terms of relative value with industry peers and offered at a fair market price. That’s obviously not the kind of statistic that fits easily with the IPO hype that characterized the last bull market. But when the IPO game does return, it would be worth keeping in mind for those executives looking to take assets public in order to genuinely boost shareholder value.