An IPO, or an initial public offering, is a way for a private company to raise capital for operations and growth by selling shares of the company to the public. But how does a business determine how many shares it should sell and at what price? In other words, how does a business determine its own value on the open market? For this, companies turn to investment banks for valuation. The valuation of an IPO is a delicate affair. If the stock is undervalued, the company can leave huge amounts of money on the table while the initial investors make enormous profits from selling the undervalued stock. If the stock is overvalued, the underwriting investment bank often needs to step in and buy up shares to shore up the price, investors lose money, and the stock could tailspin as investors try to dump shares. The dismal performance of recent IPOs like that of Candy Crush maker King Digital Entertainment (KING) shows that investment bank valuations are far from a science. In this article, we will discuss why and how investment bank IPO valuations go wrong.
The Role of Investment Banks in the IPO Pricing Process
An IPO is a complex and lengthy process. Before listing publicly, the private business gets its stock valued by analysts to determine a realistic price range. Such assessment also helps to structure the IPO to match the company’s capital raising requirements. Investment bankers are considered valuation experts. They facilitate what is called the price discovery of the private business. The investment bank will then offer large institutional investors, private investors, and other cherry-picked investors the opportunity to buy shares of the company. The catch is these initial investors must decide how many shares to purchase without knowing the exact price per share. Based on the recommendations of investment bankers, the IPO underwriter (usually an investment bank or a syndicate of several investments banks) decides what the price for one share will be (this becomes the offer price).
Investment bankers may guarantee a minimum amount of capital by purchasing the shares from the company and selling it to public through the IPO, or may simply assist in IPO process without guaranteeing any amount. They usually follow the syndication process, where multiple underwriters take tranches, or segments, of shares to be sold. (See related IPO Basics: Getting In On An IPO)
Despite an investment bank’s best efforts and exhaustive analysis, the process of taking a company from private to public means subjecting it to the whims of an unpredictable open market. On opening day, when the formerly private company enters the stock market as a publicly traded company for the first time, the opening price can go either way. An opening price that is much higher than the offer price indicates the stock was undervalued and that the company has left money of the table. An opening price that is much lower than than the offer price indicates the stock was overvalued. The closing price, short-term performance, and long-term performance of stock may also reveal errors in valuation.
Here are the primary reasons why some IPO valuations miss the mark.
- Diversity of IPO Valuation Methods: Investment bankers use a variety of valuation methods like the comparable company analysis method, the dividend discounted model, the discounted cash flow model, and the economic value-added method among others. All these models have dependencies on available data and on underlying assumptions. Different results are often observed from different models used for same stock valuation. No method fits perfectly and variety of opinion exists for pricing as various market participants (other than the underwriting bank) value the IPO differently. The selection of quantitative methods by investment bankers versus perception by other market participants is a primary source of variance in IPO pricing.
- Ambiguity in Business Perception: Today's business world is evolving in a complex manner. Innovations are emerging with a mix-n-match approach especially for tech companies who are finding interesting business prospects in overlapping domains. While such developments do open doors to new business opportunities, it makes the business valuations difficult. For example Zynga (ZNGA), maker of Farmville, started as a social network gaming services company but its current classification is difficult. Is it an entertainment company, a network company, or a technology company? Which category of peer companies should it be compared against for precise valuations? Attempts to value a stock on sector categorization and peer comparison leads to imperfect valuations.
- Future Business Proposition: Although the IPO price determination process involves a large and diversified group of market participants, this assessment group still remains relatively small compared to the overall market. This group may have its own perception of valuation which may differ from that of the overall market. This group owns IPO pricing up until the opening day when the market takes control of share prices. The market perceives valuation mostly in terms of future potential, which can change dramatically in a short time span. Despite profitability and pipeline of other games, King Digital Entertainment (KING) and Zynga (of Candy Crush and Farmville fame, respectively) both declined sharply. The market perception was that with only one hit game each, the companies could be one-hit wonders with grim future prospects.
- Interim Developments: Investment bankers did the perfect job—they came up with perfect offer price for the IPO. However, between determining the perfect offer price and the start of public trading, many things can happen to throw off the valuation. In the case of the Facebook IPO, shortly before going public, the company decided to significantly increase the number of shares to be sold. For example, Facebook early investor Peter Thiel increased his selling portion from 7.7 million to 16.8 million shares, effectively cashing out of the company. Such developments affect the supply and demand of shares and hence the opening day pricing. Investment banks may not be in full control of such developments.
- Use of Raised Capital: The primary purpose of an IPO is to raise capital. A company is required to mention how it plans to use the raised capital in its IPO prospectus. However, such purpose of fund usage can deviate post IPO. The IPO price may be determined based on the stated future expansion plans using IPO proceeds. But due to interim developments, a company may use the funds to repay the existing debt. Such developments significantly affect the price valuations leading to price changes. The investment bank's role is limited to IPO and its valuations are based on available (and intended) information. Deviation in business activities post IPO is not under the control of investment banks and leads to price deviations.
- Lack of Transparency: Transparency, responsibility, and accountability may be compromised in an IPO listings. The lead underwriters of the Facebook IPO (Morgan Stanley and 32 others) paid $38 per share for their respective stake. They sold their shares at starting price of $42.05 leading to an instant profit of $4.05 per share on the listing day. Allegedly, this sell-off led to price decline. Facebook and its underwriters were sued for fraud. In the paper, "The Need for Transparency, Responsibility and Accountability: the Case of the Facebook IPO," by Cervellati et al, the problem lies with "lack of transparency, wrong corporate culture, and conflicts of interests and behavioral biases on part of valuation analysts.”
- Relatively Younger Companies: Gone are the days when private businesses would run for decades before going public. The American IPO market is full of young companies that lack past performance data and for whom the estimation of future cash flows is a difficult task. Given these challenges, the valuation using DCF analysis is often filled with errors that lead to IPO mispricing. An alternative for DCF, the peer group multiples, is used in such cases. However, these valuations often have biases which can lead to mispricing. The comparable multiples used in such peer group multiples valuation (like the P/E ratio or statistical measures like mean and median) are not accurate due to lack of past data.
- Disclosure of Earnings Forecasts in the IPO Prospectus: Certain markets don’t mandate necessary disclosure of an earnings forecast for an IPO. It is mandatory in United Kingdom, while optional in the United States and Canada. Common investors may not have clear insights into an earnings forecast due to which they can’t verify IPO offer price. Valuations based on nonexistent earnings forecasts are hence left to the assessment by investment bankers, which may lead to price anomalies.
The Bottom Line
Investment banks play a key role in IPO process, the most important one being the valuation of the IPO. Limited in scope of study due to above mentioned factors, investment banks may often falter in accurately pricing the IPO. Lack of accuracy in IPO valuations can lead to a company leaving huge amounts of money on the table, loss of investor confidence in IPO offerings on the market, under subscription of future IPO offerings, and dismal performance on opening day.