Part three of a three-part series on going public, covering the pros and cons of an IPO, the IPO process, and IPO valuation.
Executive summary
IPO valuation is an art obscured by spreadsheets showing hundreds of statistics. In due course price, perhaps the most important number, finally gets full attention. Companies go through the entire IPO process without knowing the price. Understanding what investors and investment bankers evaluate in determining it is the best way to set expectations.
An IPO is more often priced attractively for a bank than for a mortgage company, more often for a large cap than a small cap, and more often for a tightly controlled company than a flexible one.
Determining the offering price
The first step is identifying key valuation drivers. At the most basic level, price is the product of earnings and the price-earnings multiple. The trick is estimating the multiple. Key drivers include both operating statistics and financial ratios.
Operating statistics include production volume, margins by product, data about the servicing book, prospective growth whether organic or by acquisition, and the risks and opportunities in the business.
Financial ratios include book equity, both tangible and gross, and other balance sheet measures; net income, cash flow, and other income statement measures; and holding company capital structure, meaning enterprise value versus market value.
The art of valuation is all about projecting future performance. Careful evaluation of historical operating statistics and financial statements gives insight into competitive position, suppliers and customers, other industry participants, and the impact of economic conditions. This improves the accuracy of projections and helps the investment bank identify the appropriate peer group.
Comparables
Investment banks primarily use prices achieved by comparable companies when setting an IPO price.
Trading comparables are current stock prices of similar companies multiplied by fully diluted shares outstanding, after adjusting for options. This is the market value of common equity, the market cap. Adding debt, often net of cash, yields enterprise value.
M&A comparables are the market cap or enterprise value of companies, divisions, or assets recently sold in a publicly announced transaction. Calculation is similar to trading comps except that pricing is static as of the announcement date rather than varying day by day.
Once peers and peer transactions are identified, a wide variety of operating statistics and ratios can be compared. The price-earnings ratio usually takes the lead, not just for the last twelve months but for the current year and next year. The second most common multiple is market to book, which is price divided by book value per share.
Although an IPO is priced on current market conditions, it is common to look at multiples as trends over time to gain an appreciation for stability or volatility. Trend analysis is often most valuable across broad indices over a business cycle, since multiples for individual companies gyrate with company-specific news.
It is critical to evaluate similarities and differences in the multiples calculated for each peer. Some high-price companies trade at high multiples across the board. High-margin companies tend to trade at low price-earnings multiples, since earnings per share is high, but high market-to-book multiples. Low-margin companies may show the reverse. For every multiple, the analyst's job is to understand why it sits where it does.
The IPO discount
IPO pricing is typically at a discount to trading multiples. Offerings are often used to reward an investment bank's best customers, and the reward comes in the form of that discount. An IPO is usually priced 10 to 15 percent below expected fully distributed valuation to incentivize investors to buy. As a result IPOs typically trade up from the offering price, which ensures positive market perception. When an IPO falls in the after-market it generates bad publicity. The size of the discount depends on sector and company risk, expected volatility, and expected trading liquidity.
Pricing day
On the offer date the price is determined by the strength of the order book. Despite the apparent rigor of projections and multiple calculations, the critical question is whether prospective investors believe it, and belief shows up in actual buy orders. If the book is not strong enough, the deal will be repriced, priced at the low end of the range, or pulled.
Timing requires strong and stable fundamentals as well as a strong general market. The company needs solid fundamentals across the next several projection periods in order to report good quarterly earnings in the first few quarters after listing. Since the process itself takes four to six months, that means a year or more of stability: no negative news, no earnings surprises, no exceptions. General market conditions must also support the deal. Given those hurdles, it is fairly common for offerings to be postponed or scrapped entirely.
Considering how much art goes into the price, think about it as a range. Sensitivity analysis shows what price is achieved at various multiples and financial ratios, and is necessary to understand the complexities of market discovery and pricing.
Summary
Endurance Advisory works as an independent advisor alongside companies on IPO planning and valuation analysis: assisting with corporate strategy, risk management planning, and investor messaging; providing analytical support to test and validate underwriter recommendations; and modeling and right-sizing an offering and prospective follow-ons to align with a multi-year strategic plan and capital needs.
