IPOs

Most firms conducting initial public offerings (IPOs) are young companies for which it is difficult to forecast future cash flows. Most of them are in pioneering stage or expansion stage and their revenues are highly volatile with very high growth rates which are unsustainable in the future. To value these companies, discounted cash flow analysis is very imprecise, and the use of accounting numbers, in conjunction with comparable firm multiples, is widely recommended.

The data about the firm is also not widely available and the Draft Red Herring Prospectus (DRHP) is the only source of information of finances of the company. Relative valuation using multiples such as P/E (adjusted for leverage, growth rates) and EV/EBITDA are most commonly used for valuing IPOs. Here, we start with an already listed company and take its trading multiple as base. Then, we make adjustments for information availability (We generally reduce the multiple for non-availability of information about the company in the public domain due to its privately held nature), phase in the product development, size and growth rates.

Analysts face problems when companies which are pioneers in their industries and having new innovative but never-before-tested business models come to capital markets for raising capital. Due to their new business models, there are no comparable companies in the listed space. The dot com bubble and subsequent bust was an example of the market paying humungous multiples to new and innovative business models due to lack of complete understanding of the business. Valuing IPOs is thus a different ball-game altogether due to lack of information and comparable companies at times.