IPO Valuation: The Investor's Compass

IPO valuation is central to the Initial Public Offering (IPO) process, as it identifies the appropriate fair price at which the company's shares are to be floated to the general public. Determining this valuation is a sophisticated process that requires thorough financial expertise, market understanding, and professional analysis.

This is where the merchant bankers come in — they lead the company through the valuation process to determine fair and reasonable pricing.

What is IPO Valuation?

IPO valuation is the process of approximating a company's value prior to its going public. The aim is to determine a reasonable share price that captures the company's value, potential, and financial health.

This valuation is filed with SEBI as a Draft Red Herring Prospectus (DRHP), which contains the pricing rationale and financial information for regulatory inspection and investor disclosure.

A well-priced IPO will draw in investors, while overpricing would result in low demand and underpricing could make the company question the actual worth.

There are certain key factors that determine the value of a company at the time of its IPO. Let us discuss them in detail:

1. Market Demand

A heavily demanded IPO tends to be priced higher, as the public is willing to pay a premium for a share in the firm. But demand is not always trustworthy. Consider Paytm and LIC's IPOs, for example — in spite of high hype, both were listed at a discount, disappointing investors.

2. Historical Financial Performance

• Total liabilities and assets
• Ability to generate revenues
• Net profit
• Earnings Per Share (EPS)
• Price-to-Earnings (P/E) ratio
• Return on Net Worth (RoNW)
• Net Asset Value (NAV) per share

3. Peer Comparison

The valuation should be comparable to similar companies within the same sector. If the IPO price is much higher or lower than peers, it may raise suspicions or indicate a missed opportunity.

4. Future Growth Potential

Firms planning to grow operations or venture into new markets tend to receive higher valuations. Investors tend to pay a premium for growth potential.

5. Timing and Market Sentiment

Unless the overall market is bull-run or stable, even a strongly fundamental company can fail to attract funds at premium valuation.

6. Product and Service

Those firms that sell essential or life-enhancing goods/services are invariably priced higher, particularly if their market reach is wide.

7. Quality of Management

A clean corporate background, experienced promoters, and high-quality leadership largely increase investor trust, which positively influences valuation.

The journey to valuation is complex and involves the following steps, which are usually performed by merchant bankers:

• Gather detailed company information, such as historical financials.
• Compare financial and operational performance.
• Obtain the financials audited for precision.
• Compare the company with peers and industry benchmarks.
• Take external factors into account that impact valuation.
• Apply suitable valuation techniques.
• Organize findings into the DRHP.
• Submit the draft prospectus to SEBI for its review and sanction.

There are several different ways to value a company, and in most cases, one uses a mix of them in order to produce a more true number. Some of these involve mathematical computation while others involve analysis based on markets.

1. Relative Valuation Method

Also referred to as Comparable Company Analysis, the technique compares the issuing firm with other listed firms within the same industry. It applies important financial ratios such as:

• Price-to-Earnings (P/E)
• Earnings Per Share (EPS)
• Enterprise Value (EV)
• Revenue and Net Profit margins

Steps in Relative Valuation:

• Find peer firms within the same sector.
• Collect valuation multiples of these firms (such as P/E ratio).
• Examine variations and similarities in performance.
• Adjust for unique strengths or risks specific to the issuing company.
• Apply the average or adjusted multiple to the company's financials.

Example: Using P/E Ratio for Valuation

Let's say you're valuing a new IT firm. The average P/E multiple for the IT industry is 24. If your firm's EBIT (Earnings Before Interest and Tax) is ₹15.75 crore, and since it's a new entrant, you choose to use a conservative P/E multiple range of 15 to 20.

Estimated Valuation = P/E Ratio × EBIT

• Lower Range = 15 × 15.75 = ₹236.25 crore
• Upper Range = 20 × 15.75 = ₹315 crore

This provides you with a rough IPO valuation range to work with, balancing growth projections with market reality.

2. Absolute Valuation Method

The absolute valuation method only looks at a company's own performance and potential in order to estimate its current value. It does not do any comparison of the company to other companies in the industry like relative valuation does.

This approach applies the theory of the time value of money, i.e., money in the future is less valuable than the same amount today. Estimating future earnings and discounting them to their present value, we can find the intrinsic value of a business.

Major Steps in the Absolute Valuation Method:

• Estimate the Cash Flows
• Compute the Discount Rate
• Discount the Cash Flows
• Sum Up the Discounted Cash Flows
• Calculate the Terminal Value
• Final Valuation

3. Economic Valuation Method

The economic valuation method is a formula-only method employed in determining the value of a business. It depends on major financial information like the company's debt, market capitalization, income, assets, and other economic factors.

Enterprise Value = Cash and Cash Equivalents - Debt and Liabilities

It is a simple method but should employ correct financial figures to end up with an acceptable valuation.

IPO valuation is as much about business, future, peers, and market as it is about figures — it is about knowing all these. An adequately justified valuation not only translates into investor faith but also into laying the foundations for long-term growth after listing.

With skilled merchant bankers, careful analysis, and judicious timing, the companies can debut strongly in the capital markets.