How is The IPO Price Determined?

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How is the IPO listing price decided

Discussion Topic: 

The Initial Public Offering (IPO) is the process by which growth-driven companies sell their stocks to the public to raise capital for the first time. But do you know many types of IPO are released on the market, and how is the IPO price determined? - Here we would clarify that.

This is really worth to know about if you are preparing to invest in IPO. Else you may end up buying an overpriced IPO.

[Suggested Reading: What is an IPO? – Definition, Pros, Cons, and Process]

Types of IPO Company Issues: 

Broadly defined, there are two types of IPO we see in the primary market (i) Fixed Price IPO Issue & (ii) Book Building IPO Issue. An IPO can be made available by the company in either of the way or as a combination of both.

1> Fixed Price Issue:

In the fixed price IPO issue, the company along with their underwriters evaluates the total assets, liabilities, and every other financial aspect. Then they study those figures to determine the IPO price (face value per share).

This IPO price is fixed from the first day of issue and is printed in the order document. It does not change with the demand of the IPO. The total demand for that IPO is known only after the issue is closed. Usually, it has been seen that in fixed price issue the oversubscription levels are quite high and sometimes touches several hundred times.

2>Book Building Issue:

In the book building issue method, the price is determined during the process of IPO. There is no fixed share price; instead, the company provides a price band. The lowest price in the band is named as the ‘floor price’ and the highest price is named as the ‘cap price’.

The price band is printed on the order document. And the investors are free to bid for the desired quantity of shares with the price which they are willing to pay but within the price band. The share price is then decided based on the bids. The securities are then offered at a price in-between the floor price and cap price. The demand of that IPO is published every day as the book is built.

[Read More: How to Apply for IPO Stocks Online?]

Difference Between Fixed Price Issue and Book Building Issue: 

The below table illustrates the key differences between Fixed Price Issue and Book Building Issue.

ComparisonFixed Price IssueBook Building Issue
PricingThe share price is fixed on the 1st day of issue and is printed on the order document.The exact share price isn’t fixed. Primarily a price band is decided. The price is fixed & announced after the closing date of the bid.
DemandIt is known only after the closure of issue.It can be known every day.
PaymentThe payment needs to be made 100% in advance. Refund is given if shares are not allocated after the end date.The payment can be made after the allocation.
Reservations50% of the allocations are reserved for small investors (<=2 lakhs capital), and the rest for high amount investors.50% of allocations are reserved for the "Qualified Institutional Buyer (QIBs)", 35% reserved for small investors, and the rest for others.

How is An IPO Price Determined? 

The evaluation process to decide the IPO Price is quite complex. Several methods are applied to determine the price of an IPO. The three most common methods are described below:

How is IPO price determined

1> Factors that influence the pre-IPO valuation: 

Deciding factors that influence IPO pricing the most are:

  • The quality of stocks currently being sold in an IPO
  • The organizational or management set-up of the private company
  • The current market prices of the stocks of similar companies in the same sector
  • Company’s future growth potential
  • Financial effectiveness of Company’s business model
  • The demand from the potential customers for company’s shares
  • General overall market trend
  • Sometimes, any positive news like the company’s recent achievements, success story, or products they offer may also affect pricing.

2> Absolute valuation Method: 

Absolute valuation method is the process to estimate the company’s basic value by analyzing the company’s fundamentals according to the market value. Below list the two most popular techniques used to calculate the IPO price.

Discounted cash flow:
It is the net present value (NPV) of the anticipated cash flows from an investment as at today or at any given time. The gross revenue streams are figured out by using a series of assumptions about the future business performance and then forecasting how much this business performance can generate revenue.

Economic value:
The value is calculated mathematically by accounting the economic factors like company’s residual income, assets, risk bearing potential, and outstanding debts.

A simplified formula is: Value of equity = (Enterprise value + Value of cash and investments) - Value of debt and other liabilities

3> Relative Valuation Method: 

Relative Valuation Method determines the share price by comparing the financial health of the company in question to similar companies within the same sector. That is why this method is also known as comparable valuation. The two most popular techniques used in relative evaluation methods are as follows:

Price-to-Earnings Multiple:
It is one of the most common evaluation method used to determine share price, also known as P/E Ratio. This compares a company’s market capital to its annual income. To compute the value of the company, its estimated equity value is divided by its recent year's net income. This technique is used when the company has positive cash flows and when other companies operating in the same industry have similar growth and capital structure.

Value to EBITDA Multiple:
This method measures the total value of business operations (enterprise value), instead of measuring the value of the equity. When the enterprise value is estimated, only the operational value of the business is considered. So, it accounts for the capital value and the cash & security holdings. The investments in bonds, treasury bills, or any investment in stocks of other companies, are excluded. If you are evaluating any company which has huge outstanding debts, it will show negative earnings but will have a positive EBITDA value.

The Conclusion and Final Thoughts: 

It is very important to know how the IPO listing price is determined. Stock share price typically depends on the tangible value of the underlying assets. By using the balance-sheet information attached to the prospectus, you can calculate more or less accurate share value to determine whether the IPO shares are priced correctly or not.

Often it has been observed that fixed price issue undervalued the company’s shares at IPO listing, and is lower than the estimated market value. As a result, these stocks sell like hot cakes and later investors positively revalue the company in the secondary market. 

Book building process is comparatively more efficient. It matches the demand and supply of the shares to fix the stock price. There has no chance of price leaks, unlike the fixed price issue. As the price is determined after the IPO closure, it turns out to be mutually beneficial for everyone. Investors get a potentially positive upside and the company receives a justified amount of capital.


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