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An initial public offering (IPO) is the process by which a private company becomes publicly traded on a stock exchange. Once a company is public, it is owned by the shareholders who purchase the company's stock when it is put on the market.

For many investors, the only real exposure they have to the IPO process occurs a few weeks prior to the IPO, when media sources inform the public. How a company gets valued at a particular share price is relatively unknown, except to the investment bankers involved and those serious investors who are willing to pour over registration documents for a glimpse at the company's financials. This article will look at what investors need to know about the IPO valuation process. (For more, see The Ups And Downs Of Initial Public Offerings.)

TUTORIAL: IPO Basics: Introduction

Quantitative Components of IPO Valuation

Like any sales effort, a successful sale hinges on the demand for the product you are selling - a strong demand for the company will lead to a higher IPO price. Strong demand does not mean the company is more valuable - rather, the company will have a higher valuation. In practice, this distinction is important. Two identical companies may have very different IPO valuations merely because of the timing of the IPO as compared to market demand. An extreme example is the massive valuations of IPOs at the peak of the tech compared to similar (and even superior) tech IPOs since that time. The companies that went through IPOs at the peak received much higher valuations - and consequently much more investment capital - merely because they sold when demand was high. (Find out how companies can save or boost their public offering price with these options. For more, see Greenshoe Options: An IPO's Best Friend.)

Another aspect of IPO valuation is industry comparables. If the IPO candidate is in a field that already has comparable publicly traded companies, the IPO valuation may be linked to the valuation multiples being assigned to competitors. The rationale is that investors will be willing to pay a similar amount for a new company in the industry as they are currently paying for existing companies.

In addition to viewing comparables, an IPO valuation depends heavily on the company's future growth projections. Growth is a significant part of value creation and the primary motive behind an IPO is to raise more capital to fund further growth. The successful sale of an IPO often depends on the company's plans and projections for aggressive future growth.

Qualitative Components of IPO Valuation

Some of the factors that play a large role in an IPO valuation are not based on numbers or financial projections. Qualitative elements that make up a company's story can be as powerful - or even more powerful - as the revenue projections and financials. A company may have a new product or service that will change the way we do things, or it may be on the cutting edge of a whole new business model. Again, it is worth recalling the hype over internet stocks back in the 1990s. Companies that promoted new and exciting technologies were given multi-billion-dollar valuations, despite have little or no revenues. Similarly, companies undergoing an IPO can bulk up their story by adding industry veterans and consultants to their payroll, giving the appearance of a growing business with experienced management.

Herein rests a harsh truth about IPOs; sometimes, the actual fundamentals of the business take a back seat to the marketability of the business. It is important for IPO investors to have a firm understanding of the facts and risks involved in the process, and not be distracted by a flashy back story. (For more, see A Look At Primary And Secondary Markets.)

Facts and Risks of IPOs

The first goal of an IPO is to sell the pre-determined number of shares being issued to the public at the best possible price. This means that very few IPOs come to market when the appetite for stocks is low - that is, when stocks are cheap. When equities are undervalued, the likelihood of an IPO getting priced at the high end of the range is very slim. So, before investing in any IPO, understand that investment bankers promote them during times when demand for stocks is favorable. When demand is strong and prices are high, there is a greater risk of an IPOs hype outstripping its fundamentals. This is great for the company raising capital, but not so good for the investors who are buying shares. (IPOs have many unique risks that make them different from the average stock. For more, see The Murky Waters Of The IPO Market.)

The IPO market basically died during the 2009-2010 recession because stock valuations were low across the market. IPO stocks couldn't justify a high offering valuation when existing stocks were trading in value territory, so most chose not to test the market.

Bottom Line

Valuing an IPO is no different than valuing an existing public company. Consider the cash flows, balance sheet and profitability of the business in relation to the price paid for the company. Sure, future growth is an important component of value creation, but overpaying for that growth is an easy way to lose money in investing. (For related reading, see Investing In IPO ETFs.)

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