Importance of choosing the right valuation methods for IPO valuation

Oftentimes, you might have heard about IPOs. Well, IPO or Initial Public Offering is a method and process of selling the shares of a company to the general public, and thus it is a way to make a private company into a public company. IPO valuation is the process of valuing the company and the price of shares at the time when the IPO opens. In this article, we will take a look at some of the important things to know about IPO valuation.

Initial Public Offering (IPO)

Before we can understand, how to value an IPO, let's first understand what is IPO. An IPO is a procedure for making a private business public by offering its stock to the general public. The Security and Exchange Commission (SEC), which is the U.S. federal agency that regulates the securities industry, requires every company that is ready to file an IPO must adhere to a set of guidelines and regulations. To file an IPO, the company has to comply with strict requirements including the filing of form S1/F1, financial disclosures, necessary valuations and registration of the offering with the SEC. In this regard, IPO valuation plays a crucial role in the process of filing an IPO.

What is an IPO?

IPO stands for "Initial Public Offering" and it is a type of legal process that allows a company to make its shares available to the general public. The company makes an IPO to raise capital from the public market, and, as you might have figured out already; a privately held company becomes a public company with an IPO. When a company is ready to become a public company, it works with an investment bank or underwriter that helps to conduct the process of an IPO. This investment bank/underwriter becomes responsible for preparing the necessary papers, IPO valuation, and forms that are required by the SEC, as well as conducting the IPO and offering the shares to the public.

Who can file an IPO?

This is one of the most common questions when it comes to IPOs. Before you issue an IPO, you must understand that there are a couple of things that must be considered. One of them is whether your company can even qualify to do an IPO. To qualify for an IPO, your private company should have a valuation of $1 billion, also considered a unicorn. However, based on the competition in the market and their capacity to fulfil listing standards, private companies at different values with sound fundamentals and demonstrated profitability potential may also be eligible for an IPO. As a result, you may consult with your underwriter for more details on your company's eligibility for an IPO.

Benefits of an IPO

Before you decide to file a company for a public offering, you must look into the advantages of going public. The following are some of the benefits of filing an IPO:

1. Raising funds - Filing for an IPO is a great way to raise substantial amounts of capital, which can be used to fund the growth or expansion of your business. It opens up the room for broader investment options, which can result in funding your company from a larger investor pool.

2. Increased liquidity - An IPO can increase the liquidity of your company's shares because buying, selling, and trading the shares of public companies is easier, faster and more efficient than that of a private company.

3. High credibility - Being listed on a public exchange allows your company to derive much more credibility, particularly in the eyes of other investors. Due to this, they will be able to perceive you as a credible company.

4. Financial support for M&A deals - If a private company is looking to buy another company, this process is facilitated more efficiently with an IPO. In addition, it also gives a better chance of negotiating a better deal for your business.

5. Retaining and attracting employees - By going public, your company will have much more leverage when it comes to retaining important employees and attracting the best candidates from the entire industry.

IPO Valuation

If a private company is planning to file for an IPO, then you should be well acquainted with the importance of IPO valuation. Identifying the value of the business and the share price at the time the IPO opens is crucial. Underwriters or investment bankers are generally responsible for the IPO valuation. The process is initiated by these entities, who are experts in business valuation and data analysis. In the following section of the article, we will understand some of the key aspects of IPO valuation.

What is IPO valuation?

A company's shares must be reasonably valued before an IPO. The IPO value refers to the share price and business valuation at the time the IPO opens. IPO valuation is generally determined by the underwriter, who acts as the investment bank. Accordingly, they prepare the necessary papers, deal with financial reporting, form S1/F1, and examine the company's financials, including the assets, liabilities, performance, potential for profit, and other disclosures before the company files its IPO. As a result, IPO valuation plays an important role in determining the opening share price.

When is the IPO valuation conducted?

IPO valuation takes place during the filing of an IPO. In other words, the IPO valuation is a business assessment of your company right before it files for its IPO. The investment bank or underwriter completes the formal valuation as well as prepares a report with the results. The value of your company is measured using different approaches, while the pricing of the shares is determined. Based on the detailed analysis, a valuation report is prepared and likewise filed with the SEC.

Key aspects of IPO valuation

Now that you know what exactly IPO valuation is, it's time to understand the key aspects of an IPO valuation. In this section, we will talk about some of the key aspects of the IPO valuation process:

1. To make informed judgements during an IPO, investors examine the company's financials, assets, liabilities, revenue production, performance, and other aspects.

2. The facts present in the company's financials are used to determine the company's valuation and subsequently the price of the share.

3. Before the final audit, these data are evaluated. A prospectus is prepared and lodged with the authorized stock exchange based on the findings of this audit.

4. Lastly, a date for the offering is set, and shareholders decide on the IPO's price. The shares are then listed on the exchange.

IPO valuation methods

While conducting an IPO valuation, you must ensure that you have a thorough understanding of the different methods used in the process. The following are some of the common IPO valuation methods:

1. DCF method – Discounted cash flow or DCF method is used to value a company. Using this method, the discounted cash flow model is applied to the project's expected stream of cash flows over the next 5 years. The revenue streams are anticipated by making several assumptions about the future performance of the business. The projected or anticipated cash flows are discounted using a discount rate that results in the present value of the project. As a result, the valuation of the company is based on the net present value derived.

2. Price-To-Earning valuation method - This ratio compares a company's market capitalization to its yearly revenue. The price-to-earnings multiple is calculated by dividing the company's projected equity value by its latest net income. This strategy is employed when the firm maintains favourable cash flows and comparable expansion and capital structure to other companies in the same industry. As a result, the P/E multiple valuations are a handy method used to determine the worth of a company's shares after an IPO.

3. Economic valuation method - Economic valuation is essentially a mathematical assessment that takes into account a set of criteria. These characteristics include residual revenue for the firm, liabilities to be paid off, asset value possessed and obligations to be released, risk-bearing potentials, and so on. The economic valuation method is used for a wide range of purposes and the mathematical formula is the value of equity = Value of cash and investments + enterprise value – the value of debt and other liabilities.

4. Value to EBITDA valuation method - Rather than assessing the value of the stock, this multiple evaluates the value of the company's activities or the enterprise value. The operational value of the firm is taken into account when determining the enterprise value. As a result, it takes into account holdings of cash, securities, and capital worth. Investments in treasury bills, bonds, or stocks of other businesses are not included. Thus, the value to EBITDA multiple is a standard formula that is widely used.

What are the factors that affect IPO valuation?

When conducting an IPO valuation, certain factors and considerations must be taken into account. These factors include:

1. The number of stocks sold in an IPO is important because it affects the share price. Depending on the number of shares issued, it can affect the price either positively or negatively.

2. The price of an IPO is usually measured against the price of similar stocks in the market. Hence, you must review the share value of similar companies in the same sector and industry.

3. The growth potential of a company plays a crucial role in determining its valuation and IPO price. The higher the growth, the higher the share price, and thus a stable, long-term company will command a higher share price.

4. The general market trend plays an important role in determining the IPO valuation and share price. It is crucial to keep track of market trends and strategy.

5. While conducting an IPO valuation, you must pay attention to the potential or projected demand and supply of your company’s shares.

Which is the right IPO valuation method?

While conducting an IPO valuation, different methods can be employed. These methods vary from one situation to another, as each case is unique. The right valuation method is the one which gives you a fair assessment of your company and its share based on its growth, risk-reward, and other factors. Be sure to evaluate the situation, look at the market trends, and determine the right method. It is important to note that you must be aware of the requirements of the SEC and choose a method that complies with those requirements. As a result, you will be able to comply with the various requirements of the SEC and thus deliver a fair valuation report.