How are companies valued for IPO?
New-age or old-economy business: Investors cheer most IPOs
On 10th November, FSN E-commerce Ventures Limited (Nykaa), a new-age company listed on the stock exchanges at a huge 79% premium. Similarly, on 15th November, Sigachi Industries, an old-economy company or traditional business, listed on the stock exchanges at a whopping 250% premium. Irrespective of the valuations or nature of business (traditional or new-age), most IPOs, these days, are getting listed at a huge premium. In this article, we will understand how various stakeholders value the companies for IPO.
For ease of understanding, we will divide the article into two parts: How traditional businesses are valued and how new-age businesses are valued. Let us start with traditional businesses that have been in existence for decades. Then we will move to new-age businesses that are the flavour of the season.
Valuation of traditional businesses
Most traditional businesses that come up with IPOs are profit-making businesses. Since the business generates profits and has assets, it can be valued based on traditional valuation parameters. These can be sub-categorised into two: financial and non-financial parameters.
The financial parameters include P/E ratio, P/B ratio, EBITDA and net profit margins, dividend yield, overall debt, etc. The non-financial parameters include promoters’ background, quality of management, corporate governance standards, promoter pledging of shares, etc. Let us discuss some of these parameters.
Price-to-earning (P/E) ratio
For a profit-making company, the price-to-earning (P/E) ratio is one of the most commonly used parameters for valuing the company. The P/E ratio is calculated as follows:
P/E ratio = Market price per share / Earnings per share
The P/E ratio of the company is then compared to the P/E of peer companies and the industry average.
The market assigns a high P/E ratio to certain sectors and the companies within that sector. For example, most IT companies trade at a high P/E ratio due to good growth in sales and profits, EBITDA margins, zero debt, free cash flows, regular dividends, etc.
As seen in the above table, most IT companies have a P/E ratio in the range of 30 to 60.
On the other hand, the market assigns a low P/E ratio to certain sectors and the companies within that sector. For example, most metal companies trade at a low P/E ratio due to the highly cyclical nature of the business, high leverage, high finance costs, Government regulations, etc.
Price-to-book (P/B) ratio
The price-to-book (P/B) ratio is usually used for valuation of financial services companies such as banks and NBFCs. The price to book ratio is calculated as follows:
P/B ratio = Market price per share / Book value per share
A lot of PSU banks trade at a P/B ratio of less than 1. However, most private banks trade at a P/B ratio of more than 1 due to their superior growth with better asset quality than PSU banks.
Other financial parameters
Some of the other financial parameters considered for valuing a traditional business include the companies' margins (EBITDA and net profit margins). A superior profit margin means the company has good pricing power. The overall debt of the company is also considered important for the valuation of the company. A debt/equity ratio of less than 1 is considered ideal from a valuation point of view.
Most IT and FMCG companies are debt-free and enjoy free cash flows. The free cash flows can be used for dividend payment, which is also an important factor from a valuation point of view. The higher the company's dividend yield, the better the valuation that investors will give the company.
Apart from the above-discussed financial parameters, some non-financial parameters are important from a valuation point of view. These include promoters' background, quality of management, corporate governance standards, promoter pledging of shares, etc.
If the background of promoters is shady, the company doesn't get the desired valuation. Some companies, such as Tata group companies, HDFC group companies, Infosys, etc., trade at higher valuations compared to other companies in the same industry due to the good quality of management, best in industry corporate governance standards, etc. If the promoter has pledged a majority of their shares with financial institutions for loans, the investors will be concerned and give the company a lower valuation.
In the above section, we have discussed some of the valuation parameters for traditional businesses. Now let us turn our attention to new-age businesses, which are the flavour of the market right now.
Valuation of new-age businesses
Most new-age businesses that come up with IPOs are loss-making businesses. Since the business does not generate profits and doesn't have too many assets (most of these businesses are just intermediary platforms), they cannot be valued based on traditional valuation parameters such as P/E ratio, P/B ratio, EBITDA and net profit margins, dividend yield, etc.
Most of these companies are valued based on parameters such as the total addressable market of the segment they operate in, the company's market share, the scope for the company to grow its market share, the path to profitability, and other parameters. Let us discuss some of these parameters.
Total addressable market and future growth
One of the important parameters for valuing new-age companies or start-ups is to look at the current size of the addressable market that they operate in. How much is the total addressable market expected to grow in the future.
For example, in the case of Zomato, you will have to look at the total addressable market for online food ordering at the moment. You will have to make projections on how much the online food ordering market will grow in the next 3, 5, or 10 years.
Company’s current market share
Within the total addressable market, how much is the new-age company’s market share? How much will the company be able to grow its market share in the future?
For example, in the case of Zomato, what is the company’s current market share as of today? How much will Zomato be able to grow its market share in the next 3, 5, or 10 years?
Revenues and margins
Investors will take into account how much revenue the company is earning and the margins on it. In the case of Zomato, investors will look at the average order value the company receives. How much is the company's share in the total order value? For example, if the average order value is Rs. 1,000 and Zomato's share is 15%, it will get Rs. 150 as its share.
From the revenue share, the company has to meet all its expenses. Zomato will have to spend money to acquire new customers, meet operating costs, pay delivery partners, etc. The discounts and cashbacks are a big expense for most start-ups for acquiring new customers and maintaining existing customers.
Unit economics and path to profitability
Most start-ups work on unit economics and have a 1, 3, or 5-year path to profitability. They review this regularly to check whether they are on track to achieve the desired goals that they have set.
For example, Zomato will have the unit economics regarding how much revenue they are earning from each order and how that revenue is getting spent on servicing each order. They will also have a roadmap for profitability.
Whether it's a traditional business IPO or a new-age company IPO, two important factors that matter include the stock market condition and the demand for the company shares. If the stock market is booming, then even average IPOs get lapped up by investors. But, when the market is in a down phase, only good quality companies with reasonable pricing will find buyers. The demand for IPO company shares also plays an important role. If the stock markets have been eagerly waiting for the IPO company, they will still be lapped up even if the shares are priced at a premium.
The Zomato IPO had both these important factors in its favour. The market was booming at the time of the Zomato IPO, and it was the first big IPO from the start-up space for a long time, for which the investors were eagerly waiting.
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