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Financing Best Practice

Price Discovery in IPOs

by Jos van Bommel

Executive Summary

  • When a company goes public, the issuer’s intermediating investment bank (aka the underwriter, bookrunner, or lead manager) expends efforts and resources to discover the price at which the firm’s shares can be sold.

  • Buy-side clients also expend effort and resources to value the firm. The market price will be a weighted average of the many resulting value estimates.

  • To discover the price at which the issue can be sold, the issuer helps buy-side clients with their analysis by providing a prospectus and meeting with their analysts during road show meetings.

  • To extract newly produced information from the market, the issuing team asks selected buy-side clients for their indications of their interest.

  • Investment banks compensate buy-side clients for their costly analysis by setting the price at a discount from the expected market price.

  • In addition, investment banks allocate more shares to those buy-side clients who are more helpful in the price discovery exercise. Because of the repeated interaction between banks and their clients, free riding is curtailed, and price discovery is optimized.

Price Discovery

The most important, yet most difficult, part of the initial public offering (IPO) process is setting the offer price. In an IPO, the issuer, aided by an intermediating investment bank, plans to sell a relatively large number of shares of common stock in which there is at that point no market. However, they know that soon after the IPO process the secondary market will impute all the information in the market in an efficient manner. Investors who believe the price to be too high will sell; investors who believe the price to be too low will buy. The key outcome of this competitive trading is the market price of the stock.

Naturally, the issuing team (the issuer and its investment bank would like to know the market price in advance. If they had a crystal ball, they would set the price at a small discount (say 3%) to the future market price, so as to generate sufficient interest from buy-side clients, and place the issue. In fact this is exactly what issuers do when they sell securities which already have a market price. Unfortunately, there is no secondary market for IPO shares, and neither are there crystal balls.

To estimate the market price as best as they can, issuers and their advisers conduct a costly analysis to estimate the value of the firm. We call this process price discovery.

Note that not only do the issuer and its investment bank analyze the firm. Prospective investors also conduct costly analysis to predict the future market price. Naturally, a good estimate of the future market price gives them a substantial advantage in their dealings with the issuer: If they have strong indications that the offer price is set too high, they stay away from the offering. If they believe the price to be below the future market price, they sign up for IPO shares enthusiastically.

Enterprise Valuation

There are two main methods to estimate the market value of the firm: multiple analysis, and discounted cash flow (DCF) analysis.

Multiple Analysis

When employing the multiple method, analysts gather performance measures of the firm. A popular measure is earnings or net income. They multiply these performance measures with multiples. The appropriate multiple for a firm’s earnings is the price–earnings ratio, or P/E. The multiples are obtained from similar firms, (so-called proxies, or pure-plays). For example, if listed paper manufacturers trade at an average P/E of 9, and we want to estimate the value of an unlisted paper company that recently reported a net income of $1 million, we would estimate the market price to be $9 million. Because this single estimate is bound to be imprecise, analysts collect many performance measures so as to get many estimates. Popular accounting performance measures are earnings, sales, operating income (EBIT), and cash flow (EBITDA). Apart from these, analysts use industry-specific performance measures such as passenger miles (for airlines), overnight stays (for hotels), or page visits (for internet companies). By employing more and more multiples, analysts aim to arrive at an ever more precise estimate of the market price.

Discounted Cash Flow Analysis

A more fundamental valuation method is discounted cash flow analysis. In an efficient market, securities should be worth the present value of the future cash payments that accrue to the shareholders. Since cash today is always more valuable than cash tomorrow, investors discount projected future cash flows at the opportunity cost of capital. For example, if investors want to value a one-year promissory note of $100, and the one-year interest rate is 10%, they conclude that the note is worth $100/1.10 = $90.91. If future cash flows are uncertain (risky), investors use a higher discount rate (see p. 896 to see how the discount rate depends on risk).

Apart from deciding on an appropriate discount rate, investment analysts forecast the company’s free cash flows, which are defined as the cash generated by operations less the cash dedicated to new investments. Often, young companies do not distribute cash flows to their financiers, but instead solicit cash from the financial markets. In fact, this is an important reason for doing an IPO in the first place. Naturally, the investments are expected to add to the future cash flows. Hence, analysts often predict negative free cash flows early in life, but expect them to become positive as the firm matures.

Forecasting a firm’s free cash flows is difficult. To obtain reasonable conjectures, analysts make a model to project the revenues, expenses, and investments. Analysts’ models can be very sophisticated. They analyze the products or services that the company provides, conduct industry analysis to gauge where the company stands vis-à-vis its competitors, consult market forecasts (of the firm’s products and production costs), interview the firm’s executives and other employees (as far as this is allowed by the laws that govern financial markets), and conduct sensitivity analysis.

Whatever method investment analysts use to estimate the market value of as yet untraded securities, valuing financial securities is a task that requires skill and effort.

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Further reading

Books:

  • Draho, Jason. The IPO Decision: Why and How Companies Go Public. Cheltenham, UK: Edward Elgar Publishing, 2006.
  • Gregoriou, Greg N. Initial Public Offerings: An International Perspective. Oxford: Butterworth-Heinemann, 2006.

Article:

  • Benveniste, Lawrence M., and Walid Y. Busaba. “Bookbuilding versus fixed price: An analysis of competing strategies for marketing IPOs.” Journal of Financial and Quantitative Analysis 32:4 (1997): 383–403. Online at: dx.doi.org/10.2307/2331230

Websites:

  • IPO Financial Network (IPOfn) news, analysis, and resources: www.ipofinancial.com
  • IPO Monitor—Coverage of IPOs and secondary equity offerings: www.ipomonitor.com
  • IPO Renaissance Capital—research and investment management services on newly public companies: www.ipohome.com

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