The Meaning of IPO Valuation & How It Is Done: Explained

IPO or Initial Public Offering is a process where a private company offers its shares to the general public for purchase for the first time. Here, the process of IPO valuation occurs before the public issuance of stocks. This process of valuing the price of shares is crucial as a miscalculation can result in a loss for the company willing to go public. Furthermore, investors who wish to participate in the IPO may have queries regarding its valuation.

Read along to know the meaning of IPO valuation and how it is determined!

The procedure by which an analyst calculates and determines the fair value of the shares of a company willing to go public is known as IPO valuation. This calculation procedure depends on several internal as well as external factors. Two identical firms may have entirely different IPO valuations due to these factors.

Now that you know its meaning, let us understand how to calculate IPO valuation.

To decide the price of an IPO, the issuing company hires a merchant banker who plays an advisory role and helps shareholders decide the IPO price. After deciding the price, that issuing company discloses the process in an offer document of public issue.

Here, the market body or any regulatory authority does not play any role in fixing the price of securities.

Follow the next section to learn about various methods of valuing IPO.

The methods used for IPO valuation are as follows.

1. Relative Valuation

When investment banks choose the relative valuation method to set the price of shares, they thoroughly analyse the closer benchmarks in industry and companies that are already present on the stock exchange. Here, they focus on factors like cash flow, earnings per share, and price to earnings ratio.

2. Absolute Valuation

While adopting the Absolute IPO valuation calculation process, investment banks consider Discounted Cash Flow (DCF) to evaluate the financial condition and strength of a company. Contrary to relative valuation, this method focuses on the actual wealth of a company by using the time value of money and interest.

3. Economic Valuation

To complete IPO pricing with the method of economic valuation, experts have to consider assets, potential, residual income, debts of a company and other economic factors.

4. Discounted Cash-Based Valuation

In this methodology, experts assess a company’s expected cash flows, forthcoming performance potential, strong revenue sources and many more. Discounted Cash-Based valuation is tougher than the relative or absolute valuation method as wrong assessment can increase or decrease the valuation of a company.

5. Price-to-earnings Multiple Valuation

In this process, investment banks compare the market capitalisation of a company to annual income. To compute the exact value of a company, its equity value is divided by current net income. Thus, the price-to-earnings multiple comes out. Investment banks take this method to set IPO prices when they see companies have positive cash flow and other businesses under the same industry have similar growth and structure.

There are many factors that affect IPO valuation. These are as follows:

• Share market trends
• Number of stocks issued in an IPO by a particular company
• Company’s potential growth rate
• Company’s financial performance in the past
• The recent market price of companies listed on the stock exchange.

From the above discussion, one can clearly understand the meaning of IPO valuation and how it is done. Here, investors need to scrutinise the details of a company’s financial statement, history, fundamentals before applying for the issue. To gain more profits, this practice and knowledge of IPO valuation are necessary.