Valuing IPOs

In order to understand the difficulty in setting the initial price of initial public offerings, or IPOs, we need to realize that the price of securities such as stocks, at any given time, are only loosely tied to business fundamentals.

There’s no question that business fundamentals play a role in the valuation of IPOs, although other factors are well looked at as well, factors related to the market itself and the anticipated relative demand of the stock seeking to be initially priced.

There is a lot of money involved and spent on IPOs, so it’s not that the people behind them aren’t afraid to seek out the best expertise they can in order to ensure that the best price is set. With the market being fairly unpredictable though, this is easier said than done.

One of the real challenges that face those who seek to properly value IPOs is that valuing them in the very short term is going to be a lot different task than valuing them long term. Institutional investors, for instance, are going to be a lot more interested in the longer term value of a stock than someone just looking to trade it over a short timeframe.

Therefore, the fact that we sometimes see big run ups past the issue price initially may not bother the company behind the stock as much as we might think, even though it perhaps should be a bigger issue than it is. The reason why is that while the company may miss an opportunity to get more for their stock initially, those within the company who are looking to cash in on this will be doing so later, well after the stock has had a chance to run up.

On the other hand, overpricing the IPO involves a mistake as well, especially considering that the big money from institutional investors is seen as so essential to launching an initial public offering of a stock. These are the folks that investment banks are most concerned about, and they therefore seek to strike a balance between keeping these very large investors and the companies that they work for happy.

When an IPO is overpriced, this may even prevent a successful launch, as if the price exceeds the demand for a stock, it may not even be able to be placed in the market properly. We could say that the stakes therefore are even higher to not get it wrong on the high end than if they get it wrong on the low side, because underpriced IPOs can still go off pretty well, and a lot of people, including and perhaps most importantly including the initial shareholders of the company.

The Market Environment with an IPO

One of the first things that an investment bank looks at when seeking to launch an IPO is the current market conditions overall at the time. If you release an IPO during a bear market for instance, the results are going to be considerably poorer than if it were released during a bull market.

Investment banks understand the nature of the markets in the macro sense, which influences both the market and individual stocks far more than individual investors usually realize. Whether one should be in the stock market at all can be seen as dependent upon market conditions, even though investors will most often ignore this to some degree, perhaps only paying attention after a great deal of damage is done to their portfolios.

Valuing IPOsCompanies aren’t going to want to wait years for bear markets to turn around though, although current market conditions will still influence whether a company chooses to go public at a given point in time.

This is one of the reasons why we tend to see more IPOs during bull markets, especially strong ones, as this does motivate companies who may have been considering issuing an IPO to cash in now while things are going so well.

If the demand for stocks in general is high, reflected in market averages, then the demand for IPOs will tend to be higher as well. When the demand for stocks in general is lower, people are getting out of stocks more than they are getting into them, so this decreased demand will also influence people’s desire to own an IPO just like it would with owning any stock.

Given the importance of this, it does not just come down to overall market conditions, the longer-term trends, as shorter-term trends matter as well. This may affect the timing of the release of an IPO, and since market trends can be distinguished on a weekly and even a daily basis to some extent, this can affect the timing of the release of an IPO, and especially, its pricing.

For the most part, a company wants to release an IPO and they generally don’t want to wait very long for it to be issued, so this is why market conditions become more a matter of not when to issue it, but how much to issue it for.

If the market isn’t taken into account enough, this will not allow for demand to be accounted for properly. Demand is ultimately the decider of stock prices, purely and simply and absolutely. If demand isn’t accounted for enough, this is certain to lead to errors.

The Influence of Business Fundamentals on IPO Valuation

Business fundamentals do play a role in the valuation of IPOs, more so because institutional investors in particular tend to pay a fair bit of attention to this. There is a risk that these factors may be overvalued though, especially because the benchmark is not where the stock will be over the longer term, in a few years or even in a few months, what where it will go out of the gate.

The reason is that this is what the company will be paying the most attention to, where the demand for the stock is on the date it is offered to the public, and if for instance the new stock is issued at a certain price and it quickly rises quite a bit, they may rightly wonder why the stock wasn’t issued at a higher price.

This may be, to some degree, that the analysis relied upon fundamental data too much, even though it may seem reasonable to do so. What a company’s financials or their competitiveness in their market may seem reasonable criteria, this only influences stock prices to the extent that it influences demand, and demand is where the rubber meets the road here, completely.

Once the stock hits the secondary market, it is too late if demand for it has been underestimated, and especially given the excitement that IPOs tend to generate among the investing public, a degree of mania can set in where the price paid gets run up from this excitement.

Even though this initial demand may not be sustainable, it may leave the company wondering what might have been, since their take depends upon what the demand is for their stock initially, not at some point in the future, or whether or not their stock may be able to sustain such a high price.

If the process of IPOs were different, for instance if the stock was released more gradually, the way that large institutions place orders, there is little doubt that the IPO could capture more value for the company offering the stock. That’s not how the process works, and anytime you release such a large amount of stock into the market at once essentially, this is going to have an effect.

It’s actually pretty amazing that underwriters who issue the stock do as well as they do and come as close as they do, given this challenge, and while they do have to cater to the longer- term criteria that the large investors who take on the stock initially subscribe to, this is simply a cost of doing business and being able to place the IPO successfully, at least in the framework of the methods that they are placed.

So, we will see things like earnings and other financial criteria playing a fairly influential role in the pricing of IPOs, as well as what is perceived as the company’s future prospects, even though these factors may not end up playing as big of a role in the initial trading price of the stock in the very short term.

Valuing IPOs Based Upon Comparative Value

Another major factor used in pricing IPOs, and one that makes perfect sense to use, is those seeking to properly price the IPO looking to the value of the stock of comparable companies in the market.

This is often not so easy to do though due to the fact that companies do differ, as well as due to the fact that IPOs are a different form of animal, where we could say that an IPO is much more sensitive to hype than an established stock would be.

The mere fact that the value of an IPO is a relative unknown can serve to remove normal limits on the movement of its price. When traders and investors evaluate future trends with a stock, they will look to historical price data to a large extent, and this will serve to temper their expectations in many cases.

This isn’t the case with IPOs as there is no historical data to rely on. Still though, there are companies out there who may be deemed to be comparable, and we may therefore look to the price of their stock as well as their historical data to seek to gain a good idea of where the IPO should settle in at once the initial frenzy subsides.

This is not to say that all IPOs are subject to a buying frenzy, as this only really happens when the initial price is set well below the market, as well as only with particular offerings. Most of the time they do though, by a significant degree, and this can be said to be to some degree a reflection of the degree of undervaluation of IPOs.

Once again, where a company’s stock may settle into shouldn’t even be an issue in their pricing, but it’s hard to get around that given the different objectives of IPO investors, where a lot of the initial investment is focused on these later projections.

IPOs do generate a lot of money for the companies who issue them though, regardless, and each year, there are tens of billions of dollars’ worth of IPOs that hit the market. Companies benefit, underwriters benefit, and IPOs are very popular with investors as well, so regardless of the fact that the initial demand for a stock may be more accurately predicted than we often see, IPOs remain very popular indeed.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.