How is the price of a stock decided in an IPO and who decides it?

Since Indian IPOs are predominantly through the book built route, we shall focus on the indicative pricing of the book built issues in this article.

Feb 17, 2019 10:02 IST India Infoline News Service

Initial Public Offer, IPO
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.

Related Story

Open Free Demat Account (Rs699)
Open ZERO Brokerage Demat Account

  • 0

    Delivery Brokerage for Lifetime

  • 20

    Per order for Intraday, F&O, Currency & Commodity