– Kartikeya Kaushik
In recent years, India has witnessed a surge in Initial Public Offerings (IPOs), driven by a booming equity market and growing interest from both retail and institutional investors. IPOs are considered a key mechanism for companies to raise capital and for investors to gain access to equity in promising businesses. Investment banks play a crucial role in determining the valuation of companies before their shares are offered to the public. However, there have been numerous instances in India where IPO valuations have seemingly missed the mark, with the stock prices of certain companies rising significantly above their listing prices and staying elevated for a prolonged period. This disparity has led to questions about the accuracy and efficacy of IPO valuations conducted by investment banks.
How IPO Valuations are Conducted
IPO valuations are a critical aspect of the process by which a company goes public. Before a company lists its shares, it partners with investment banks, which act as underwriters. These underwriters are responsible for assessing the company’s value and determining how many shares should be sold and at what price. The core purpose of this exercise is to balance the interests of the company looking to raise capital and the investors who want to gain equity ownership at a fair price.
IPO valuation typically involves multiple factors, including:
1. Company’s Financial Performance: Investment banks assess the company’s historical financial data, including revenue growth, profitability, and future projections. They look at earnings before interest, taxes, depreciation, and amortisation (EBITDA) and profit margins to establish a baseline valuation.
2. Market Comparables (Comparable Company Analysis): Investment banks analyse publicly traded companies in the same sector, focusing on their price-to-earnings (P/E) ratios, price-to-book ratios, and other valuation multiples. This method helps the banks benchmark the company against its peers and adjust its valuation accordingly.
3. Discounted Cash Flow (DCF) Analysis: In this approach, banks project the company’s future cash flows and discount them to their present value using an appropriate discount rate. This method provides a more intrinsic valuation based on future expectations rather than current market conditions.
4. Market Sentiment: Investment banks also consider the broader market environment, such as investor appetite for risk, prevailing interest rates, and the economic outlook. Positive sentiment can lead to higher valuations, whereas bearish conditions may result in conservative pricing.
5. Growth Potential: A company’s growth prospects are a crucial part of its valuation. Investment banks factor in the potential for expansion, new product launches, or market opportunities that may drive future revenue and earnings.
Determining the Price Band in an IPO
The valuation methods culminate in the determination of a price band, which is a range within which the shares will be offered to the public. The price band serves two purposes: it gives investors a sense of the expected price and allows flexibility in pricing based on demand during the IPO process.
The price band is typically set through a “book-building process”, which is essentially a demand assessment mechanism. In this process, institutional investors submit bids for the shares, stating the number of shares they are willing to buy and at what price within the specified range. Based on the demand at different price levels, the final price is decided.
The key steps in determining the price band are:
– Issuer’s Expectations: The company going public has an expectation of how much capital it wants to raise and what valuation it hopes to achieve. This is communicated to the underwriters during negotiations.
– Feedback from Institutional Investors: Investment banks engage with institutional investors, such as mutual funds and hedge funds, to gauge their interest and willingness to participate in the IPO. This feedback helps to determine if there is strong or weak demand for the shares.
– Investor Roadshows: The company’s management team and underwriters embark on roadshows, presenting the investment case to prospective investors. Feedback from these interactions plays a role in deciding the final price band.
– Final Pricing Decision: Once the book-building process is complete and demand is gauged, the underwriters decide on the final issue price based on the bids received, often near the higher end of the price band if demand is strong.
Investment Banks’ Role in Indian IPO Valuation Failures
Despite these rigorous processes, there have been several instances in the Indian context where investment banks have failed to accurately value IPOs, leading to significant discrepancies between the listing price and subsequent stock market performance.
1. Zomato IPO (2021): One of the most talked-about IPOs in India was that of food delivery platform Zomato. The company went public at a price of ₹76 per share, and on the day of listing, its share price soared by 65% to close at ₹125. The stock price continued to remain significantly above its issue price for months, with investors expressing optimism about the company’s growth potential. This dramatic rise called into question whether investment banks had undervalued the IPO, leaving substantial gains on the table that could have been captured by the company instead of early investors.
2. Nykaa IPO (2021): The fashion and beauty e-commerce platform Nykaa listed its shares at ₹1,125 after an initial issue price of ₹1,085. However, upon listing, the stock skyrocketed by nearly 80% and continued to trade at elevated levels, peaking at over ₹2,500 in a few weeks. This stark difference between the issue price and post-listing performance highlighted a potential undervaluation by the underwriters.
3. MapmyIndia IPO (2021): C.E. Info Systems, the company behind MapmyIndia, had an issue price band of ₹1,000 to ₹1,033 per share. Upon listing, the stock jumped to ₹1,500, a 50% increase from the issue price. Despite the growth potential in the digital mapping space, the sharp rise in the stock price again indicated that the IPO had been underpriced.
4. Paras Defence IPO (2021): Another example of underpricing was the Paras Defence IPO, which had a price band of ₹165-175. Upon listing, the stock opened at ₹475, nearly three times the issue price. This stark contrast between the offer price and the trading price underscored concerns about the underwriters’ ability to assess market demand accurately.
Reasons for IPO Valuation Failures
There are several reasons why investment banks may fail to accurately value IPOs, particularly in the Indian context:
1. Conservative Pricing: Investment banks often take a conservative approach to IPO pricing to ensure the issue is fully subscribed. By setting the price slightly below the perceived market value, they increase the likelihood of demand outstripping supply, resulting in a successful listing. However, this conservative pricing can sometimes lead to a significant rise in stock prices post-listing, indicating that the company was undervalued.
2. Market Sentiment Misjudgment: Investment banks may misjudge the prevailing market sentiment. In bull markets, investor optimism may push prices higher than expected, resulting in stock prices rising sharply after listing. This was evident during the IPO boom in 2021 when overall market conditions were buoyant.
3. Unanticipated Retail Investor Demand: The surge of retail investors in India, particularly during the pandemic when many new investors entered the stock market, has added another layer of complexity to IPO valuations. Retail investors often drive up demand post-listing, leading to higher stock prices, a factor that underwriters may not have fully anticipated.
4. Sector-Specific Growth Optimism: Investment banks may underestimate the growth potential of companies in rapidly growing sectors like technology, fintech, or e-commerce. In cases like Zomato and Nykaa, the high post-listing performance can be attributed to the optimistic outlook of investors in the tech and consumer sectors.
Conclusion
The role of investment banks in IPO valuations is critical, yet there have been multiple high-profile cases in India where these valuations have seemingly failed to reflect market demand. The consistent trend of stock prices rising and staying above the listing price highlights a potential underestimation of the growth potential or market demand by investment banks. While the process of IPO valuation involves several complex steps, including analysing financials, market sentiment, and investor feedback, the surge of retail investors, sectoral growth optimism, and conservative pricing strategies have often led to underpricing. This creates opportunities for public investors to benefit from significant short-term gains, but it also raises questions about how companies and their underwriters should approach IPO pricing in the future.
Leave a comment