IPO Valuation – A Quick Communication with Prof. Peter M. DeMarzo (Stanford Graduate School of Business, USA)

Hi Prof. Peter,

I am referring to the 4th Edition of the Corporate Finance textbook (https://www.amazon.com/Corporate-Finance-4th-Pearson-Standalone/dp/013408327X),

Chapter 23 under 23.2 “The Initial Public Offering”, section “valuation” which said:

Before the offer price is set, the underwriters work closely with the company to come up with a price range that they believe provides a reasonable valuation for the firm using the techniques described in Chapter 9. As we pointed out in that chapter, there are two ways to value a company: estimate the future cash flows and compute the present value, or estimate the value by examining comparable companies. Most underwriters use both techniques. However, when these techniques give substantially different answers, they often rely on comparables based on recent IPOs.

However, when looking into Chapter 9, I do not find any mention about pre-money and post-money valuation.

Normally, for IPO purposes, since the company is going to issue new shares to be offered to the public, instead of the existing shareholders selling their shares to the public (Note: they could do so, post IPO, and there could be a lock-up period, let’s say, one year in certain country, for existing shareholder to be not being able to sell their shares), it is important to see how much the value of the company before and after the IPO proceeds flowing into the company’s bank account. The planned use of the IPO proceeds will be required to be disclosed in the prospectus and this will impact the IPO valuation, as the analyst needs to assess how much the added value of that use to the whole valuation.

 

The reply from Prof. Peter

Hi Karnen,

Yes, it is a good point worth mentioning that the value will be based on the anticipated future cash flows given any new investment.  (Alternatively, the new cash raised will contribute to the equity value over and above existing enterprise value.)

Thanks again,

-Peter

 

Karnen’s responses:

Hi Prof. Peter,

This IPO valuation (or pricing in reality in view of limited number of shares being put on offer for sales to the public, resulting in the working of demand and supply law) is really interesting, though I see the Corporate Finance textbook is quite little in bringing to really appreciate it.

This IPO pricing is essentially about what the company would like to do with the IPO proceeds.

In general, we could separate the use of that IPO proceeds into:

  1. Financing a project/business totally separated from the company’s existing projects/business.
  2. Financing/refinancing current business, for example, the expansion in the same business line (opening more stores, financing working capital, capital expenditures), and/or paying down the bank loans
  3. The combination of No. 1 and No. 2 above.

In the case of No. 1 above, and assuming there is no positive/negative synergy with the current business/project, then the IPO pricing will really look into the added value (=NPV) of that new ventures divided by the number of newly issued shares.

In the case of No. 2 above, then we need to look at the equity value after being added with the NPV brought in by the expansion, etc., after factored into the valuation, the plus and minus of the synergy value. As a note, the NPV of the project will ultimately go to the equity shareholders or investors (Note: NPV project = NPV investors only holds if market value of the debt is identical to book value of the debt. If the debt is traded one, such as bonds, then this could not hold). Then the IPO pricing is the new equity value divided by the total number of common shares (current shares + new shares).

Jakarta, August 2017

Posted in VALUATION.

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