To a certain type of investor, few scenarios are more rewarding than getting in on the ground floor of an investment opportunity and then watching it rise while the latecomers scramble to get in. It's the modern equivalent of staking a gold claim on an overlooked part of the Klondike.

The chances of finding IPO gold are slim but the allure is strong. That's why IPOs attract so much attention.

And yet, many investors in IPOs have little idea how that valuation was determined.

The IPO Process

An initial public offering (IPO) is the process that transforms a privately-owned enterprise into a public company whose shares are traded on a stock exchange. When a company goes public, it is owned by the shareholders who purchase its stock.

Key Takeaways

  • Is the company a game-changer? That will be a factor in its IPO valuation.
  • Other factors include industry comparables and the company's future prospects.
  • Beware the hype and read the financial statements!

The only real exposure many investors have to the IPO process occurs a few weeks in advance when the news breaks. How any company's valuation is established is relatively unknown except to the investment bankers involved. Whether that valuation is reasonable can be known to serious investors who are willing to comb through the registration documents to understand the company's financials.

The Components of IPO Valuation

Like any sales campaign, a successful IPO hinges on consumer demand for the product. A strong demand for the company will lead to a higher stock price.

Demand

Strong demand does not mean the company is more valuable. It means the company will have a higher valuation.

In practice, the distinction is important. Two identical companies may have very different IPO valuations merely because of the timing of the IPO in terms of market demand.

IPOs are introduced when demand and prices for stocks are high. High demand equals higher valuation.

An extreme example is the massive valuations of IPOs at the 2000 peak of the tech bubble compared to the similar or even superior tech company IPOs since that time. The companies that went public at the peak received much higher valuations, and consequently scored much more investment capital, merely because they launched when demand was high.

Industry Comparables

Industry comparables are another aspect of IPO valuation.

If the IPO candidate is in a field that has comparable publicly-traded companies, the IPO valuation will in part be based on the valuation multiples being assigned to its 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.

Growth Prospects

In addition, 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 plans and projections for aggressive expansion.

A Good Story

Some of the factors that play a 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 more powerful than 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 having little or no revenues.

Similarly, companies can polish up their story by adding industry veterans and consultants to their payroll to give the appearance of a growing business with experienced management.

That is the harsh truth about IPOs. The actual fundamentals of the business can be overshadowed by the IPO marketing campaign. The only defense from a flashy back story is a firm understanding of the facts and risks.

Facts and Risks of IPOs

The objective of an IPO is to sell a pre-determined number of shares at the best possible price.

Very few IPOs come to market when the appetite for stocks is low. When stocks are undervalued, the likelihood of an IPO being priced at the high end of the range is slim.

So, before investing in any IPO, understand that investment bankers promote them during times when the demand for stocks is favorable.

When demand is strong and prices are high, there is a greater risk of an IPO's hype outstripping its fundamentals. This is great for the company raising capital, but not so good for the investors who are buying shares.

For example, the IPO market virtually disappeared during the 2009-2010 recession because stock valuations were low across the market. IPO stocks couldn't justify a high offering valuation when established stocks were trading in value territory.

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How An IPO Is Valued

Dos And Don'ts of IPO Investing

Don't be swayed by publicity and news coverage.

Groupon, Inc. (GRPN) debuted in January 2011, when local couponing services were widely touted as the next big thing on the internet. Groupon opened at about $28.40 on its IPO date and then sank like a stone. As of early July 2019, it was trading at about $3.50.

As with any investment, you need to do your research before committing money. A couple of hours hovering over prospectuses and financial statements can earn you a great payoff, or at least save you a false move.

As the old saw goes, you make your money going in. A lucrative but overpriced investment is not as good as a mildly profitable but underpriced one.

One problem is that incipient IPOs usually haven't been around long and never have a long history of financial disclosure. But in order to launch an IPO, they have to produce balance sheets, income statements, and cash flow statements.