How an Initial Public Offering (IPO) Is Priced

An initial public offering (IPO) is the process by which a privately-owned enterprise is transformed into a public company whose shares are traded on a stock exchange. This process is sometimes referred to as "going public." After a private company becomes a public company, it is owned by the shareholders who purchase its stock.

Before the public issuance of the stock, an investment bank is hired to help determine the value of the company and its shares before they are listed on an exchange. For investors, it's not always easy to determine if that price is fair.

The best method to determine if stock that is newly issued and has not traded previously on an exchange is priced appropriately is to analyze the company's financials, which can be accessed by looking at its registration documents, and compare them to similar listed companies. In addition, understanding the various components of how an investment bank conducts a company's IPO valuation is important for anyone interested in becoming an early investor.

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 dotcom 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 it 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.

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.

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 $524 (split-adjusted). After that, it sank and kept sinking—in mid January 2024, it was trading at about $13 per share.

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. A 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.

The Bottom Line

Investment banks working on behalf of the company wanting to go public play a key role in determining how much it should be valued at the time of its IPO. How much demand there is for the type of shares being offered is carefully considered as is the valuation of similar companies already listed and the excitement the private company’s growth prospects can generate.

Investing at the IPO stage isn’t easy. Often hype can overshadow the fundamentals and valuations become inflated. Generally, the best way to determine if the asking price is fair is to not get caught up in the marketing narrative and examine the company's financials and future prospects objectively with a clear head.