In this blog post, we’ll discuss IPO price-setting mechanisms. The price range set for an IPO depends on multiple factors. Its fundamental goal is to provide a slight discount on the actual trading value of the company. The goal is to keep investors happy and facilitate post-launch share trading.
So what are the main ways to value a company’s shares?
The typical IPO process lasts between 4 to 6 months. Toward the end of the process, pricing becomes a topic of animated discussions. Company ownership becomes anxious. Investment bankers organize meetings with potential investors, where the top management team delivers presentations and explains what lies ahead of the company.
At the end of these meetings, investors express their intentions and provide feedback. All this is done to determine the price investors are willing to pay on the day of the IPO. As usual, discounted cash flow is the primary technique to determine a company’s price. It consists of calculating the present value of all cash flows the company is expected to produce in the future. The basis for this valuation is projections, relying on historical results and the business plan prepared by the management team. So, the DCF model establishes a possible price range.
But what other factors play a role?
Another valuation technique practitioners apply to triangulate results is multiples valuation. This approach consists of finding comparable companies listed with similar businesses in terms of industry size, geography, and competitive strategy. Analysts calculate a ratio between the prices of these public companies and their operating results. This ratio can be multiplied by the IPO firm’s operating result, so analysts obtain a sense of the implied market valuation of the business. This is another technique we will cover in the program. It’s easy to imagine why the shape of the economy can be extremely important when deciding to list a firm.
Nobody wants to conduct an IPO when financial markets are turbulent and market prices decrease. Many IPOs were canceled in 2008 when the global financial crisis erupted. In times of crisis, market multiples tend to shrink as investors become much more cautious, and therefore valuation ranges significantly decrease. Towards the end of the IPO process, investment bankers’ valuation estimates improve significantly. After each meeting, bankers receive feedback about investors’ willingness to buy shares at different price points so institutional investors can tell the bank how many shares at various price points they are willing to purchase. This process is called book building.
At the end of the roadshow, investment bankers use this information to suggest a price to the owners of the IPO company based on the information they’ve acquired. We need to remember a few important facts. Ideal pricing is at a reasonable discount to the company’s trading value. Book of demand is the most important tool when discussing pricing limits from anchor orders and investors heavily involved in the process are a crucial signal for the optimal price. Pricing is a long and challenging discussion with the company and its shareholders.
In conclusion, we should remember the following pricing should achieve the company’s objectives while ensuring a stable after-market.
