The Components of IPO Valuation

A successful IPO hinges on consumer demand for the company's shares. Strong demand for the
company will lead to a higher stock price. In addition to the demand for a company's shares,
there are several other factors that determine an IPO valuation, including industry comparables,
growth prospects, and the story of a company.

Demand
Strong demand for a company's shares does not necessarily mean the company is more valuable.
However, it does mean that the company will have a higher valuation. An IPO valuation is the
process by which an analyst determines the fair value of a company's shares.

Two identical companies may have very different IPO valuations simply because of the timing of
the IPO and market demand. A company will usually only undergo an IPO when they determine
that demand for their stocks is high.

In 2000, at the peak of the bubble, many technology companies had massive IPO valuations.
Compared to companies that went public later, they received much higher valuations, and
consequently, were the recipients of much more investment capital. This was largely due to the
fact that technology stocks were trending and demand was especially high in the early 2000s; it
was not necessarily a reflection of the superiority of these companies.

Industry Comparables
Industry comparables are another aspect of the process of IPO valuation. If the IPO candidate is
in a field that has comparable publicly-traded companies, the IPO valuation will include a
comparison of the valuation multiples being assigned to its competitors. The rationale is that
investors will be willing to pay a similar amount for a new entrant into the industry as they are
currently paying for existing companies.

Growth Prospects
An IPO valuation depends heavily on the company's future growth projections. The primary
motive behind an IPO is to raise capital to fund further growth. The successful sale of an IPO
often depends on the company's projections and whether or not they can aggressively expand.

A Compelling Corporate Narrative

Not all of the factors that make up an IPO valuation are quantitative. A company's story can be
as powerful as a company's revenue projections. A valuation process may consider whether or
not a company is offering a new product or a service that may revolutionize an industry or be on
the cutting edge of a new business model.

A good example of this is the companies that pioneered the Internet in the 1990s. Because they
were promoting new and exciting technologies, some of them were given valuations of multiple
billions of dollars, despite the fact that they were not producing any revenue at the time.
Some companies may embellish their corporate narrative by adding industry veterans and
consultants to their payroll, trying to give the appearance of being a growing business with
experienced management.

Sometimes the actual fundamentals of a business can be overshadowed by its marketing

campaign, which is why it is so important for early investors to review a company's financials
and be aware of the risks of investing in a company that doesn't have an established trading
history.

Risks of Investing in IPOs

The objective of an IPO is to sell a pre-determined number of shares at an optimal price. As a
result, companies will usually only conduct an IPO when they anticipate that the demand for
their shares will be high.

The IPO market nearly disappeared during the stock market dip that occurred between 2009 and
2010 because stock valuations were low across the market.

When demand for a company's stock is favorable, it's always possible that the hype around a
company's offerings will overshadow its fundamentals. This creates a favorable situation for the
company raising capital, but not for the investors who are buying shares.

Volume 75%
 
When investing in an IPO, don't be swayed by media hype and news coverage.
When Groupon, Inc. (GRPN) debuted in January 2011, local couponing services
were widely touted as the next trend. On its IPO date, Groupon's stock opened
around $28.40. Unfortunately, after that, it sank and kept sinking. In January
2020, it was trading at about $3.00.

An IPO is no different than any other investment; investors need to do their

research before committing any money. Reviewing prospectuses and financial
statements is a good first step. One challenge of investing in IPOs is that the
companies usually haven't been around for very long and they don't have a long
history of disclosing their financial information. However, part of the process of
launching an IPO is that companies are required to produce balance sheets,
income statements, and cash flow statements for the public.
IPOs, Their Pros, Cons, and the IPO Process

Four Ways an IPO Can Hurt or Help Your Business

•••
Table of Contents

 Four Advantages 
 Four Disadvantages
 What IPOs Mean to the Economy
 The IPO Process
 The Bottom Line
BY 
KIMBERLY AMADEO
 
REVIEWED BY 
ERIC ESTEVEZ
 
Updated November 25, 2020

An IPO is short for an initial public offering. It is when a company initially offers shares
of stocks to the public. It's also called "going public." An IPO is the first time the owners
of the company give up part of their ownership to stockholders. Before that, the
company is privately-owned.

Four Advantages 
The IPO is an exciting time for a company. It means it has become successful enough
to require a lot more capital to continue to grow. It's often the only way for the company
to get enough cash to fund a massive expansion. The funds allow the company to
invest in new capital equipment and infrastructure. It may also pay off debt.
Stock shares are useful for mergers and acquisitions. If the company wants to acquire
another business, it can offer shares as a form of payment.

The IPO also allows the company to attract top talent because it can offer stock options.
They will enable the company to pay its executives fairly low wages up front. In return,
they have the promise that they can cash out later with the IPO.

For the owners, it's finally time to cash in on all their hard work. These are either private
equity investors or senior management. They usually award themselves a significant
percentage of the initial shares of stock. They stand to make millions the day the
company goes public. Many also enjoy the prestige of being listed on the New York
Stock Exchange or NASDAQ.

For investors, it's called getting in on "the ground floor." That's because IPO shares can
skyrocket in value when they are first made available on the stock market.

Four Disadvantages
The IPO process requires a lot of work. It can distract the company leaders from their
business. That can hurt profits. They also must hire an investment bank, such
as Goldman Sachs or Morgan Stanley. These investment firms are tasked with guiding
the company as it goes through the complexities of the IPO process. Not surprisingly,
these firms charge a hefty fee.

Second, the business owners may not be able to take many shares for themselves. In
some cases, the original investors might require them to put all the money back into the
company. Even if they take their shares, they may not be able to sell them for years.
That's because they could hurt the stock price if they start selling large blocks. Investors
would see it as a lack of confidence in the business.

Third, business owners could lose ownership control of the business because the Board
of Directors has the power to fire them.
Fourth, a public company faces intense scrutiny from regulators including the Securities
and Exchange Commission. Its managers must also adhere to the Sarbanes-Oxley Act.
A lot of details about the company's business and its owners become public. That could
give valuable information to competitors. 

What IPOs Mean to the Economy

The number of IPOs being issued is usually a sign of the stock market's and economy's
health. During a recession, IPOs drop because they aren't worth the hassle when share
prices are depressed. When the number of IPOs increase, it can mean the economy is
getting back on its feet again.

The IPO Process

According to the Corporate Finance Institute, there are five steps in the IPO process. 1

Select Lead Investment Bank

First, the owners must select a lead investment bank. This beauty contest occurs six
months before the IPO, according to CNBC.2 Applicant banks submit bids that detail
how much the IPO will raise and the bank's fees. The company selects the bank based
on its reputation, the quality of its research, and its expertise in the company's industry.

The company wants a bank that will sell the shares to as many banks, institutional
investors, or individuals as possible. It's the bank's responsibility to put together the
buyers. It selects a group of banks and investors to spread around the IPO's funding.
The group also diversifies the risk.

Banks charge a fee between 3% and 7% of the IPO's total sales price.

The process of an investment bank handling an IPO is called underwriting. Once

selected, the company and its investment bank write the underwriting agreement. It
details the amount of money to be raised, the type of securities to be issued, and all
fees. Underwriters ensure3 that the company successfully issues the IPO and that the
shares get sold at a certain price.

Due Diligence

The second step is the due diligence and regulatory filings. It occurs three months
before the IPO. This is prepared by the IPO team. It consists of the lead investment
banker, lawyers, accountants, investor relations specialists, public relations
professionals, and SEC experts.

The team assembles the financial information required. That includes identifying, then
selling or writing off, unprofitable assets. The team must find areas where the company
can improve cash flow. Some companies also look for new management and a
new board of directors to run the newly public company. 

The investment bank files the S-1 registration statement with the SEC. This statement
has detailed information about the offering and company info. The statement includes
financial statements, management background, and any legal problems. It also
specifies where the money is to be used, and who owns any stock before the company
goes public. It discusses the firm's business model, its competition, and its risks. It also
describes how the company is governed and executive compensation.

The SEC will investigate the company. It makes sure all the information submitted is
correct and that all relevant financial data has been disclosed.

Pricing

The third step is pricing. It depends on the value of the company. It also is affected by
the success of the road shows and the condition of the market and economy.

After the SEC approves the offering, it will work with the company to set a date for the
IPO. The underwriter must put together a prospectus that includes all financial
information on the company. It circulates it to prospective buyers during the roadshow.
The prospectus includes a three-year history of financial statements. Investors submit
bids indicating how many shares they would like to buy.

After that, the company writes transition contracts for vendors. It must also
complete financial statements for submission to auditors.

Three months before the IPO, the board meets and reviews the audit. The company
joins the stock exchange that lists its IPO.

In the final month, the company files its prospectus with the SEC. It also issues a press
release announcing the availability of shares to the public.

The day before the IPO, bidding investors find out how many shares they were able to
buy.

On the day of the IPO, the CEO and senior managers assemble at either the New York
Stock Exchange or NASDAQ for the first day of trading. They often ring the bell to open
the exchange.

Stabilization

The fourth step is stabilization. It occurs immediately after the IPO. The underwriter
creates a market for the stock after it's issued. It makes sure there are enough buyers to
keep the stock price at a reasonable level. It only lasts for 25 days during the "quiet
period."

Transition

The fifth step is the transition to market competition. It starts 25 days after the IPO, once
the quiet period ends. The underwriters provide estimates about the company's
earnings. That assists investors as they transition to relying on public information about
the company.

Six months after the IPO, inside investors are free to sell their shares.
The Bottom Line
A private corporation becomes a public company through an IPO. It sells shares of
ownership or stocks to the public market. Going public allows the company to gain any
of four advantages:

 An expansion through a huge capital boost.

 Capacity to acquire or merge with another company.
 Facility to competitively attract talented management.
 Enormous increase of investment value for the original private investors.

But an IPO also poses disadvantages:

 Process incurs huge costs.

 Original owners may not be able to sell their shares of stock immediately, as doing so
could reduce the stock price.
 Control of the business goes to the Board of Directors. This may or may not be
comprised of the original corporate owners.
 Company is now under constant scrutiny by the SEC.

The IPO process takes five steps:

 Selection of an investment bank

 Due diligence and filings
 Valuation
 Stabilization
 Transition to market competition.

The volume of issued stocks in the market could indicate the economy’s health. A
decrease may signal a recession, while an increase may express an economic upswing.