What Is Involved in IPO Valuation?

Jim B.
Jim B.
Woman holding a book
Woman holding a book

An IPO valuation is performed by the underwriters of an initial public offering, to determine the optimum price for newly-issued stock once it becomes available to the public. Meanwhile, investors attempt to perform their own valuations to decide how much the stock is worth and to decide whether it is a worthwhile investment. Since there is no previous market action on stock available in an initial public offering, an IPO valuation by underwriters can be based on the earnings and cash flow of the company issuing the stock. Investors will look to intangibles like management style when performing their valuation, while also comparing the market action of companies in a similar industry to the IPO.

Performing a valuation on a publicly-traded company that is well-established on the stock market is made easier by the past performance of the stock and the years of financial reports the company has filed. By contrast, a company that goes public to investors for the first time via an initial public offering, or IPO, may not provide measurable information for investors to study. When this is the case, an IPO valuation is far from an exact science.

For the underwriters of the IPO, the IPO valuation is a process meant to not only determine a reasonable market price but also to stimulate the action of investors. Underwriters often discount the initial price from what their valuation determines so that investors will be attracted to try out the new company. Still, the underwriters are accurate more often than not, as a large number of companies that offer IPO's end up trading at prices very near their initial level.

Investors have to determine via an IPO valuation whether the stock's price is inflated or underrated. Most investors understand that the initial offering will attract many investors and, therefore, the price will surge accordingly. Once that surge has waned, an accurate valuation is crucial to determine the long-term prospects for the stock.

If the company that is offering the new stock has been in existence for a while, investors can use some of the tangible financial information on record, such as cash flow, income, and debt, to make a solid IPO valuation. But, if that information is limited or even nonexistent, other methods must be devised. Knowing the track record of the company's management can help predict how it will do in the future. In addition, inspecting how other like-minded businesses performed on the market can give an indication of what direction the new offering will go.

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