Pricing IPOs: Science or Science Fiction? (1999)

A look at the intricate art of taking a company public. It's show time. After months of preparation, your company's initial public offering (IPO) will start trading this morning. You spent yesterday afternoon anxiously tracking the market. The investment bankers canvassed their institutional brokers to assess interest in your stock. The company finance and accounting staff have spent countless hours preparing for the day. The final decision: The company will sell 2 million shares at $20 each, for a total offering of $40 million. The investment bankers say demand for your IPO looks strong, and they expect your stock to open with a pop. That prediction proves true--the shares open at $23 and the price moves steadily higher throughout the trading day, finally closing at $25. Although the stock's strong first-day performance is gratifying, you can't shake the feeling that you might have mispriced the IPO. The calculations run through your mind: Each $1 increase in the offering price would have generated $2 million more for the company. The thought nags you--did you sell too cheaply? When an IPO quickly moves to a significantly higher price during its first day on the market, it's natural to wonder if the investment bankers--and the issuing company's officers--didn't misprice the deal. Although the market for IPOs has cooled recently, some offerings still post impressive first-day gains. In mid-June, for example, 6 million shares of GOTO.com came to market at $15 and closed at $22.375, after trading as high as $28.50. Not too long ago, Internet and technology IPOs routinely doubled in value on their first day. That kind of volatility makes it inevitable to second-guess. The MarketWatch.com offering exemplifies the incredible demand that has existed for these issues. The company, an online financial news service, went public January 15, 1999, with an offering price of $17. It closed the day at $97.50, an increase of 474%. In another instance, theglobe.com went up 606%, from $9 to $63.50 on its first day, in November 1998. These enormous price surges raise questions about whether traditional valuation methods remain valid. Not surprisingly, however, investment bankers and CFOs who have taken their companies public recently dispute the notion that IPO pricing rules have changed. WHAT'S IN A NUMBER? Investment bankers say the valuation process is as much an art as a science. The scientific part of the pricing equation is based on numbers: an issuer's historical and projected financial results, as well as valuations for comparable companies. The art is in the investment banker's assessment of market conditions and investors' demand for the new issue. Pricing an IPO is always a function of the valuation, says Charles J. Kaplan, president of Equity Analytics. That's what you have to determine first. Kaplan, whose company advises privately held firms wishing to go public, points to a range of valuation multiples used to estimate a company's market value. Let's assume a food distributor or a food processing company wants to go public. We look at income before interest and dividends and put a multiple on that. If it is a relatively slow-growth industry, the multiple will be lower; if it's a fast-growing company, we'll use a higher multiple. The multiple probably won't go higher than 10 or lower than 2 or 3. Estimating a company's value begins well in advance of the IPO date. Businesses planning to go public typically interview several investment banking firms before selecting one to underwrite the offering. The investment bankers, in turn, investigate the company to determine if they want to handle the deal. They perform a detailed review of the company's finances, the quality of its management team and the company's position in its major markets. The investment bankers also consider comparables, which are publicly traded companies in the same industry as the IPO candidate. …