Prior to listing a stock for sale on a public exchange, companies go through a rigorous process of preparation and compliance.
In addition to providing the SEC and the public a detailed prospectus about their team, background, and finances, they must come up with a suggested starting price for each share they plan to sell in their IPO. This price then creates an IPO valuation for the company.
There are a variety of factors and steps that are used to determine the IPO price. Here’s a closer look at the IPO valuation process.
What Is an IPO?
When privately-owned companies, such as unicorn companies, begin to sell shares of stock to the public, they hold an initial public offering, or IPO. This is called “going public.” Prior to an IPO, companies are owned by the founders, employees, and early investors such as venture-capital firms and angel investors.
An IPO can help a company bring in significant funds for expansion. They can also be a source for publicity. However, the IPO process is also time consuming and expensive, and once a company has gone public, it faces new challenges such as increased scrutiny and the need to please shareholders.
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Why Do Companies Go Public?
The number of publicly traded, exchange-listed companies in the U.S. has gone down from the peak in the mid-to-late 1990s, when it reached about 8,000. In late 2020, the figure was closer to 6,000 companies, which traded on different stocks exchanges, such as the New York Stock Exchange and Nasdaq.
Holding an IPO is a huge and risky undertaking, but can create significant value for a company. The main reason companies choose to go public is to raise money. In many cases, IPOs raise millions and even billions of dollars.
Other reasons companies go public are to gain media attention, grow a broad base of financial supporters, and please venture-capital firms that helped fund the company in its early stages.
Bringing in public investment benefits the business, but it also benefits early investors and employees. Those who have invested time and money in a company can sell their shares following an IPO.
That’s because when an individual joins a company, sometimes they are granted employee stock options. The options are often given over a number of months or years–a process called vesting. Usually employees must wait to sell their vested stock until the end of a “lock up period”–a span of time after an IPO during which employees have to wait before selling their shares.
Steps in IPO Valuation
How Underwriting Works in IPOs
When a company decides to hold an IPO, they work with an investment bank to come up with the price. The process of investment bankers handling an IPO is called underwriting. Each underwriting process can be slightly different, but the factors that investment bankers consider in order to determine IPO prices are essentially the same. Some questions include:
• Why has the company decided to go public?
• What is the current status of the market?
• Who are the company’s competitors?
• What are the company’s assets?
• How much has been invested in the company and by whom?
• What is the history of the company and its team?
• What are the company’s prospects for growth?
Process of Determining IPO Prices
The rules of supply and demand which apply to most products also apply to stocks. As an investor, what are you willing to pay for each share of a company when it decides to go public? The process of IPO pricing goes like this:
Prior to an IPO, the ownership of Company X is divided into equal shares. The existing owners each own a certain number of these shares. These owners include the founders, early employees, and any venture capitalist and angel investors who already own a stake in Company X.
When Company X decides to go public, the existing owners are selling off a portion of the company to investors in order to raise capital. The money raised in the IPO goes into the company’s bank account, and the percentage of ownership of each of the initial owners goes down.
To create a balance in this tradeoff that makes both existing and new owners of the company happy, the company must decide how many new shares to issue, and the price they plan to sell each share for in the IPO. The company’s executives and their investment bank come up with the number of new shares by determining how much money they hope to raise and are willing to give up.
Institutional Investors in IPO Process
Once executives and bankers decide on the number of new shares, they reach out to institutional investors to start asking them how many shares they are interested in buying. Institutional investors include hedge funds, mutual funds, high net worth individuals, and pension funds in good standing with the investment bank.
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These investors come up with estimates about the price based on their own analyses, and rumours begin to circulate about the IPO price.
Days before the IPO, the institutional investors place requests for how many shares they actually want to purchase. Company X then sets the price for the IPO, and they know exactly how much money they will raise.
The underwriting investment bank goes through the complex process of figuring out the allocation of all the shares to the institutional investors. They want to create a balance of different types of investors, and they have knowledge about each of the investors which factors into the allocations.
Retail Investors in IPO Process
When the public IPO market opens, the institutional investors hold the shares, and orders start coming in from retail investors. Unfortunately for the at home retail investor such as yourself, it can be nearly impossible to buy a stock at its IPO price. Some brokerage platforms like SoFi have started to offer IPO Investing services that allow individuals to buy closer to the IPO price.
But retail investors often buy at a markup, even though some companies have been known to trade below their IPO price on the first day. The investment bank for Company X takes a look at all the incoming orders, which may be either buy or sell orders, and reports the predominant price.
They then go through a process of price discovery to determine what the opening price will be. The goal is to have the maximum number of trades be executed from all the placed orders. At Nasdaq this is done electronically, while at the NYSE, human traders are involved.
When they set the price they input all the existing orders, the opening IPO price is now set, and the trading day continues.
In an ideal situation for the company and the underwriters, the closing price of the stock on opening day is fairly close to the opening price. This means the shares are priced accurately for what investors are willing to pay for them.
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However, the IPO price isn’t necessarily a good indicator of the value of a stock. Broader market interest in the stock is impossible to plan for, and IPO conditions differ from the long term presence of the company in the market.
You can determine the value of shares sold using the IPO price formula of the number of shares sold divided by the total amount of capital paid in. These numbers can be found in the company’s prospectus document.
One of the goals of an IPO is to gain positive media and investor attention, so companies hope to see immediate increases when their stock debuts. IPOs are generally priced with a goal of going up or “popping” on opening day. This ‘discount’ also acts as a cushion to protect the stock from falling. Ideally, the stock holds its value until the company reports its first-quarter earnings.
Do IPO Stocks Always Rise?
Highly talked about IPOs have disappointed in their opening weeks at the markets. This may be because investors feel these companies are overvalued and don’t want to risk putting money into them when they haven’t yet shown a profit.
It also isn’t uncommon in the world of tech IPOs. Data from Dealogic shows that since 2010, around ¼ of IPOS in the U.S. have seen losses after their first day. This is both costly and disappointing, since so many months of planning go into holding an IPO.
It can take time for a stock to increase following an IPO, so the initial sale isn’t necessarily an indicator of long term success or failure. The frenzy of the sale doesn’t always result in an immediate rise, but the influx of new capital allows the company to grow.
New hires and expanded resources bring results a number of months, or even years, later. Many stocks experienced tumultuous action for months before seeing a steadier climb. As an investor, looking for companies which have a solid team and business plan, rather than just hype and a high valuation, can result in long term portfolio growth.
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How to Invest in IPOs
As you can see, IPOs can be very volatile. Knowing when to buy IPO stocks is a crucial part of building a strong portfolio, as is keeping a long-term perspective.
Although there is potential for significant returns, investors can also see severe losses in the weeks and months after a company goes public. Aside from researching a company before deciding to invest in it, there are other ways to mitigate risk.
Rather than investing right away, you can wait a quarter or six months to see how a company’s stock fluctuates following the IPO, and then decide whether to invest. Stocks can often fall to form a base price before beginning to rise again. Or you can just invest a small amount at first and add more later.
You can also expose yourself to a broad portfolio of new IPO stocks through an exchange-traded fund or ETF. ETFs offer a weighted balance of stocks and are adjusted over time. By diversifying your portfolio you benefit from any standout successes while avoiding huge losses.
IPOs are all over the news for a reason, it’s exciting when a company opens up to public investment! If you’re a newer investor, it can be challenging to know when and how to add new IPO stocks to your portfolio.
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