When a company sells stock, its shares are priced relative to how the company is perceived by potential investors. On a level basis, the supply of shares sold is determined based on the current share price and investors’ willingness to purchase stock.

This is based on the IPO price range, which was agreed upon by the banks and companies during the process of acquiring and selling shares. For example, when Tesla Motors Inc. (NASDAQ: TSLA) went public, the company set a business valuation range of $18-$28 per share. Investors expected the stock to start at $20.70 and to see Tesla stock soar to $29 per share, but the stock opened at $24.31, which was above the company’s proposed price range.

Why should companies consider going public?

The Initial Public Offering of shares: When a company makes its initial public offering (IPO), the company has all the cash raised from its shares available for a limited period of time to expand the company or move it into a new industry or geographic location.

This enables the company to grow without waiting for investors to fund an expansion.  Most tech companies who go public make an offering. The money they raise has a clear use, which allows them to get their money to work quickly without being reliant on investors. Instead, they can spend the money on expanding their technology or development of new products.

A corporation is usually established in order to conduct a variety of business activities. Depending on the specific industry, the role that a company plays is determined by its charter, called by various names, such as the “formal charter,” “organizational charter,” or “business plans.”  There are several types of corporate charter, which ultimately determine which entity controls the corporation.

The largest type is the registration-tax exemption-dependent, wherein the corporation is created under a different law.  Traditionally, the process for a new company to go public involves obtaining a contract with a top-tier investment bank.

The process of an IPO

It’s fairly simple to see that an IPO is not one of the most time-consuming methods of raising capital, yet it is one of the most commonly used methods. According to Investopedia, to go public, a company must first raise money through a private placement with a limited number of investors.

The proceeds from the private placement are used to finance the company’s operations and expansion. With these funds, the company will sell shares to the public through a “road show” that typically takes place six to 12 months before the IPO. Investors are able to buy the shares at a discounted price of between $2 and $12 each, although the price is typically higher during the road show.

Before a company can launch an IPO, it needs to prepare a registration statement for its shareholders to vote. In general, companies launch an IPO if they have both financial stability and reasonable prospects of meeting their growth targets. It is a bit more complicated to actually go through with an IPO, though, as the majority of IPOs take place in the United States.

At first, a company must approach an investment bank for a “proposal” (a term that refers to the way in which a company’s IPO registration statement is structured) with the intention of going public. The investment bank will then determine whether or not they believe that the company has the financial capability to raise the amount of capital that it desires.  This is where the term “market comparables” comes into play.

The valuation of a company before its IPO

A company’s valuation is the value of its equity. It is established by taking into account multiple factors, such as the company’s growth rate, future plans, revenue and expenses, the demand for its products, and other factors. An accurate business valuation helps a company and its investors determine whether an IPO is worth taking a risk on.  Revenue estimate is determined after an executive, board, or outside consultants have identified the target market, determined which companies in that market are its competitors, estimated its brand strength and distribution capability, and analyzed trends and other indicators to gauge the level of penetration into the target market. Once these factors are determined, a revenue estimate is calculated.

The importance of good research

Investors should always look for credible research sources and objective news publications for further insight into the company. While several news publications and opinion columns are great sources for news coverage on emerging companies, investors should be wary of what is written by employees and other insiders.

Insider trading laws protect public companies that are aware of company news, but the actions of insiders, when they trade stock based on material nonpublic information, is still considered insider trading, even if they pass it on to public analysts.

The importance of timing

The IPOs of some companies are incredibly valuable and a good early investment, while for others it may not be such a wise move.  More companies than not will be acquired within the first 18 months of their IPOs, and this can give a nice boost to its share price.

But by selling shares below the IPO price, the company also allows a lot of institutional investors to purchase shares at a discount to the initial IPO price, and this can lead to a speculative bubble in a company’s shares. It is always important to understand that not all IPOs are created equal and that a few flops are also involved in any IPO.

How to calculate a company’s worth

Despite the importance of evaluating the various factors that determine an IPO valuation, the decision as to whether a stock is worth an investment can sometimes be a subjective one, especially for new issuers. The best way to determine whether a stock is worth an investment is to look at a company’s fundamentals and its financial statements, which can be found in its registration documents.

Market capitalization

Market capitalization refers to the total value of shares issued, which includes both shares of common stock and shares of preferred stock. Market capitalization is used to establish the total value of the company and the overall public perception of the company.

Market capitalization is a measure of a company’s market value. To calculate a company’s market capitalization, investors use stock prices. Stock prices are the total number of shares outstanding divided by the listed price. An IPO listing involves a company selling a significant number of shares of its stock for the first time.

Price-to-earnings ratio

Because an IPO is a unique investment opportunity, valuations depend on a lot of factors such as the industry in which a company operates and how fast that industry is growing. In order to gauge the growth potential of a stock, it is best to look at the competitors in the industry in which the company operates and identify the slowest growing competitors.

Once these companies are identified, they are then compared to the top two or three players in that industry. 

Return on equity

Return on equity is the ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) to shareholders’ equity. The higher the ROE, the more the company’s shareholders are paid in dividends and share buybacks. On an absolute level, this will increase the share price and will be included in the company’s IPO capital raise.  A company’s ROE reflects how well it uses its assets to generate returns for investors. Companies that rely on debt to fund their operations will usually generate lower ROE than those who do not.

Understanding the components of IPO valuation

It is imperative to understand the components of IPO valuation in order to properly invest in an IPO. Understanding these components of IPO valuation is the process by which an analyst determines the fair value of a company’s shares. In fact, without the understanding of the various components of IPO valuation, an investor may never invest in an IPO.

The Components of IPO Valuation

“Valuation of a stock (IPO) is just the valuation of a company when it is sold to the public by private investors, not the company’s actual business valuation,” according to Permenomics.  An analyst may value a company’s shares differently from the market-cap-weighted market value. An IPO may not be valued in the market-cap-weighted approach.

Analysts value IPOs differently than the company’s stock price. For example, the stock of a company can be valued at $100 per share or it may be valued at $1,000 per share. If the stock is valued at $100 per share and the company’s market cap is valued at $500 million, the market value of the company’s shares is $100 million.

Demand for a Company’s Shares

For an IPO to be successful, demand for the company’s shares is a critical component of the process. At the very heart of the IPO process is the current demand for a company’s shares. A company’s share price, and thus the IPO valuation, will depend on demand for the company’s shares.  Generally, demand for a company’s shares will determine the IPO valuation.

This demand includes investor demand for the shares and investor demand for the company’s shares.  If investors are bullish about the future prospects of a company, the share price is likely to rise and the company’s stock price will reflect these trends. If investors are bearish about a company’s prospects, the share price is likely to fall and the company’s stock price will reflect these trends.

Demand for Shares and Stock Price

Although demand for a company’s shares does not necessarily mean that a stock price will increase, an IPO with high demand, strong demand, and high stock price (or a combination of all three) can be a very attractive prospect for investors. One prominent example is Amazon.

The company’s IPO in 1997 was very successful. Its stock price grew from $18 per share on its first day of trading to over $100 per share after thirteen months. In addition, its stock price almost tripled in value by the end of 2000, which demonstrates that investors were very bullish about the company’s future prospects.  Meanwhile, Nasdaq began charging an additional $.02 per share to list an IPO in 1996. Since many companies would have been unable to raise the needed capital at the $.

Factors that Determine an IPO Valuation

With the recent interest in technology IPOs, a well-known value analyst has offered five factors that help determine the value of a company’s stock. When a company seeks an IPO, an analyst will compare the valuation of the company’s shares to those of public companies in the same or related industries. These factors can influence the valuation of a company’s shares.

Cash is a big part of the decision-making process for an IPO. Most companies require financing to launch their products and run their day-to-day operations. Failure to obtain enough financing can potentially lead to a devaluation of the company’s stock price.

Comparables in Industry

The case of Tesla is illustrative. Tesla used to be a small electric carmaker, now it is the largest and most popular electric car manufacturer in the world. Prior to its IPO, Tesla was valued at just over $3 billion. The valuation of Tesla reflects the $3 billion equity value, along with some debt and cash.

To put this business valuation in perspective, here are the comparable companies listed by the company in its prospectus:  2nd. by miles, and growing. As we discussed in the Introduction, Tesla is the most valuable American car manufacturer. The most valuable American car manufacturer, aside from Tesla, is General Motors (NYSE:GM).  Tesla has proven to have better technology, while GM is not as far along.

Growth Prospects

Growth prospects for a company usually determine the minimum price that a company must offer for its shares. For example, if a biotech company is being valued by a private equity company, then it will be much higher than if it is being valued by a bank or investment bank.

According to the IPO Market, a 25% growth rate has been the magic number. Investors want a company to have 25% annual revenue growth or, alternatively, 5% annual sales growth. In today’s culture, business is a competitive affair. In fact, companies looking to go public are required to disclose to the public just how many competitors they face, how many products they sell, and what the revenue and profits are.

The valuation of a company after its IPO

After the company is listed on the stock market, the price of its shares increases as more investors purchase them to trade on the market. The price increases are the result of increased supply and demand and are usually based on a hypothetical analysis conducted by the investment bank.

 A company’s share price depends on the size of the company, the investors who are trading it and the stock market, since the stock is available on a number of exchanges across the world.  The price of a stock is also determined by the amount of shares available to the public and investor demand for shares. This demand is increased by the anticipation of future success and a company’s potential for growth.

Conclusion

Having a well-known company go public is an important milestone for a company. Some businesses choose not to go public at all because of perceived risks associated with the process. Others choose to take the plunge only after substantial research and planning to determine the appropriate IPO market, the appropriate exchange and the appropriate financial instruments to be used to place their shares.

Groundwork must be laid by both the entrepreneurs and the investors who ultimately invest in the shares. There is also a very important level of education to be done by the shareholders about the risks associated with the offering.