Ipo Valuation Using Dcf

Ipo valuation using dcf

Determining the optimum price for an initial public offering (IPO) for a firm is an extremely important process. Pricing shares of a firm too high will result in significant losses for investors and tarnish the firm’s reputation while a price that is too low will result in less than optimal earnings for the firm.

This paper will examine the valuation and pricing process used to value a firm for an IPO and illustrate what happens when investment banks get it wrong.

Valuation and IPO

When a firm decides to go public, the process begins with the formation of an underwriting team.

This team includes an investment bank responsible for underwriting the securities, the firm’s management, legal counsel, and various financial consultants and advisors (Liaw, 2012). Once the team is formalized and terms are agreed upon between the firm and the investment bank, the team begins examining the firm and filing the required paperwork with the Security and Exchange Commission (SEC).

During this time, the underwriting team begins to determine the price for the offering (Brian, n.d.).

Ipo valuation using dcf

The price of the offering is dependent on several factors, including the valuation of the company, the interest of investors, the timing of the issuance, and the sentiment of the market (Stammers, 2011; Kim & Ritter, 1999). The process of setting the price begins with a valuation of the firm. This valuation provides a starting point from which the final price for the offering can be set. Although there are many methods that can be used to value a firm for an IPO, the two most common methods used are discounted cash flow analysis and the comparables method (Ritter, 1998).

Discounted Cash Flow Analysis

Discounted cash flow analysis is one of the most thorough methods of valuing a company, accounting for a firm’s future free cash flows, projected growth, and the firm’s weighted average cost of capital (Vault, n.d.). Although there are many different types of discounted cash flow analysis including the dividend discount model and the cash flow to firm approach, at its roots this method simply calculates the net present value of the sum of all future free cash flows.

Discounted Cash Flow Calculation

In order to determine the discounted cash flow for a firm, a limit must first be set for how far into the future free cash flows will be calculated.

For high growth companies with a dominant market position and high barriers to entry, cash flows may be able to be accurately estimated for as far as 10 years into the future. Slow growing companies in highly competitive environments, however, may only be able to predict their cash flows for 2 or 3 years with any accuracy (McClure, n.d.).

Therefore the selection of the time frame in which cash flows can be predicted will vary between firms and industries as it is highly dependent on context.

This value is then used for the variable n in equation (1).

(1)

Once the limit for the projected cash flows is determined, the actual value of the cash flows can be calculated.

Equation (1) includes two types of cash flow projections: the expected free cash flows E(FCFi) through the projection period and the projected terminal value TV of the firm. The expected free cash flows are determined by adjusting the projected net income for each year i as outlined in equation (2).

(2)

The terminal value TV can be calculated using a variety of methods, including using multiples applied to some cash flow such as earnings before interest, taxes, depreciation and amortization (EBITDA), net operating profit, or net income (see Comparables Method section).

Equation (3) calculates the terminal value using the Gordon Growth model.

(3)

The growth rate g used in this equation can be determined using historic growth rates for a firm, analyzing the growth for similar firms, or by examining certain fundamentals of the firm (Damodaran, n.d.).

Using historic growth rates is appropriate for a firm that has a longer history and relatively stable growth, but may not be appropriate for young firms that have not yet plateaued. Determining growth based on similar firms is a less accurate method and may not even be possible for that operate without peers in a certain market.

In this case, analyzing the fundamentals of the firm, such as the firm’s investment in new projects and the returns on those projects, may provide the most accurate prediction of future growth.

In order to calculate both the terminal value and the discounted cash flow, the firm’s discount rate must be also found. As with the other variables in this method, there are several ways to determine an appropriate discount rate, such as the weighted average cost of capital (WACC) and the adjusted present value (APV) method.

Of the available methods, the weighted average cost of capital is the most commonly used (Vault, n.d.). Firms financed only with equity and debt can calculate the WACC as indicated in equation (4) where D is the firm’s total debt; E is the firm’s total equity; rd is the average interest rate on the firm’s long-term debt; and re is the firm’s cost of equity.

(4)

For public firms, equity typically includes sources such as bonds, common stock, and preferred stock. For private firms that are in the process of issuing their IPO, equity can include venture capital funds, owner’s capital, or funds from other private investors (“Equity financing,” n.d.).

The total value of these funds is added up to determine the value of E and the total amount of debt is summed and used as the value for D. While rd can be easily calculated by examining the firm’s long-term debt, calculation of re is slightly more complicated.

Most often the cost of equity is determined by using the Capital Asset Pricing Model (CAPM) as shown in equation (5).

(5)

In the CAPM equation, re is the expected return; rf is the risk free rate; rm is the return on market; and β is a measure of the volatility of a security’s return relative to the returns of the overall market (“Weighted average,” n.d.).

Public firms can calculate their value for beta by looking at the performance of their own stock; firms that are being evaluated for an IPO cannot and so must use other techniques to determine this value.

To determine an accurate value for beta, a private firm can either use the beta value of a comparable organization or estimate an accounting beta.

Using the beta of a comparable firm runs the same risk as using the growth rate of comparable firms—namely that the value of a comparable firm may be wildly inaccurate. Estimating an accounting beta consists of performing a regression analysis of the changes in earnings for the private firm against the changes in some standard benchmark, such as the S&P 500.

In this case, the value for beta will be equal to the slope of the regression line. While this method is more accurate, it will only work for a firm that has a long enough history to provide an adequate number of data points for the regression analysis (Damodaran, n.d.-b).

What is Discounted Cash Flow Valuation?

Once all of the values for the variables are established, the cost of equity can be calculated, allowing the WACC to be calculated. Once the WACC is calculated, both the terminal value and the discounted cash flow can be calculated using equation (2) and (1) respectively.

Discounted Cash Flow Accuracy

The accuracy of the discounted cash flow valuation technique depends heavily on the reliability of the future cash flow predictions. This technique typically results in the highest value for a firm of the four methods mentioned because future cash flows are typically overstated or do not account for any unforeseen losses in sales or market share (Liaw, 2012).
Though thorough, this method does provide some difficulties for valuing companies issuing an IPO.

Most companies that conduct an IPO are young firms whose future growth and cash flows are uncertain. Given the high level of uncertainty, valuation simply based on a discounted cash flow is very imprecise. For this reason, many industry leaders recommend that the discounted cash flow method be used in conjunction with the multiples method for more accurate valuation of a firm for an IPO.

Kim and Ritter (1999) recommend that in addition to the traditional multiples used, underwriting teams should also consider using multiples such as market to book, price to sales, enterprise value to sales, and enterprise value to operating cash flows to increase the accuracy of the firm’s future value.

Comparables Method

Comparables analysis compares the target firms with other comparable transactions or companies in order to determine the target company’s implied value in the public equity market (Liaw, 2012). Valuing a firm based on comparable transactions involves finding similar firms that have gone through the IPO process and examining relevant metrics such as EBITDA and the price of the securities.

When using the comparable transactions method, the primary valuation parameter of the transaction must be determined (Vault, n.d.).

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Once this is determined, the value can be combined with market statistics and multiples in order to calculate a value for the firm in question (Fuhrmann, 2013).

In many cases, there may not be enough information available to successfully use the comparable transaction method. In this case, the comparable company valuation method may be used. Valuing a company based on comparable company analysis (also known as multiples analysis) involves determining a variety of multiples for a list of comparable firms, including enterprise value-to-sales, price-to-earnings, and EBITDA (Fuhrmann, 2013).

Once these multiples are determined for each comparable company, the results are averaged together to achieve an average value for each multiple. Determining these multiples by averaging several values together helps to account for the fact that no two firms are the same and creates a more reliable metric.

Once these multiples are established based on a list of comparable companies, they can be used to determine the value of the firm in question. For example, if the average EBITDA multiple was found to be 9%, the firm can multiply their EBITDA by 9% to determine the enterprise value and then subtract the firm’s net debt to determine their equity value.

The biggest difficulty when using this method is the assumption that there are comparable firms or transactions which may not be the case.

Discounted Cash Flow Analysis (DCF Valuation)

Even when comparable firms and transactions are available, using those values does not necessarily account for changes in the climate of the market or industry (“Comparable Transaction Analysis,” n.d.).

Additionally, this method does not account for differences in accounting techniques which may affect the accuracy of the multiples. For this reason, this method is often used in conjunction with the discounted cash flow method outlined above (Fuhrmann, 2013).

Ipo valuation using dcf

Determining Offering Price

Once a value is calculated for the firm, the underwriting team begins to establish an initial price using additional information which includes the sentiment of the market, the state of the firm’s industry, and investors’ perception of the firm.

The unique knowledge of the investment bankers on the team, such as knowledge of how the market is valuing comparable firms, is crucial during this stage (Ritter, 1998). In fact, studies have shown that the experience and expertise of the investment bankers on the underwriting team significantly contributes to the accuracy of the price of the offering (Chemmanur, Ertugrul, & Krishnan, 2013; Kim & Ritter, 1999).

Once a potential price is established, a preliminary prospectus is generated and distributed to perspective investors and brokers in order to gauge interest in the offering (Liaw, 2012). After the prospectus is distributed, the management team of the firm meets with potential investors during a key marketing event known as the road show (Liaw, 2012). During this time the team continues to gauge the market’s interest in the firm in order to further refine the final offering price.

After the road show, the team determines a final offering price for the IPO. When the price is finally announced on the day that the IPO is being issued, money from the institutional investors identified during the road show begins to flow into the company’s accounts and stock shares are released into the secondary market for trading. What happens after the stock is opened for trading largely depends on the accuracy of the pricing as discussed below.

Importance of an Accurate Price

Of the entire IPO process, arguably the most critical component and most difficult to get right is the determination of an accurate price for the stock at the time of the offering. If the IPO is valued too low, the underwriting team is essentially “leaving money on the table,” receiving less from their offering than they could have.

In this case, it is the investors in the primary and secondary market as well as any shareholding employees that will win as the stock value rises.

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This is exactly what happened with LinkedIn.

Undervalued IPO: LinkedIn

LinkedIn, an online business networking company, went public for trading on May 19, 2011. Initially priced at $45 per share, LinkedIn’s stock price rose as much as 171% during the first day of trading, closing at $94.25 by the day’s end (Olivarez-Giles, 2011). This discrepancy represents a significant undervaluation of the firm, with some estimating that LinkedIn left as much as $130 million on the table (Blodget, 2011; Ovide, 2011).

This undervaluation was caused by several factors. LinkedIn was the first major U.S. social media site to go public, a move which investors have been eagerly awaiting. Yet the number of shares offered for trading totaled only 7.84 million, accounting for less that 10% of all outstanding shares (Woo & Cowan, 2011). Using the basic law of supply and demand, it is easy to understand why an asset with high demand and limited supply experienced a substantial increase in price.

Following LinkedIn’s offering, analysts argued about the cause of the undervalued stock. Some argued that it was the fault of the underwriting team for incorrectly estimating the interest of investors and selling off shares too cheaply (Blodget, 2011; Dembosky, 2011; Ovide, 2011). Others, including Jack Ablin, the chief investment officer at Harris Private Bank in Chicago, believed that it was caused by overly eager investors (Baldwin & Selyukh, 2011; Newmark, 2011).

It is likely that the cause is a bit of both. Yet regardless of the cause, the fact remains that the price of the offering was highly inaccurate and cost LinkedIn millions (Blodget, 2011; Ovide, 2011).

Overvalued IPO: Facebook

While it was the undervaluing of an IPO that caused problems for LinkedIn, overvaluing an IPO is equally as damaging. If an IPO is priced too high, stock prices will fall after they are released to the secondary market for trading. If this happens, the firm issuing the IPO will benefit by receiving a larger amount of capital than they may have otherwise received, but investors on both the primary and secondary market will lose from participating in this deal.

Since it is the investors that lose from a firm being overpriced, it is not uncommon for this situation to tarnish the reputation of the underwriting investment bank and even the issuing firm itself (De La Merced, Rusli, & Craig, 2012). This is what happened during Facebook’s IPO.

The Facebook IPO was underwritten by Morgan Stanley and issued on May 18, 2012.

In the days leading up to the offering, the price per share was increased from an initial estimate of $28-$35 per share to $38 per share in anticipation of high investor demand (Raice, Das, & Letzing, 2012). This price valued Facebook at approximately $108 billion, the third highest valuation of a company in the history of the U.S. stock market (Geron, 2012).

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Though Facebook was one of the most highly anticipated public offerings of the year, the price of the stock fell by 11% by close of the second day, falling far below the standard 15% increase in price that most IPOs seek (Liaw, 2012; Farzad, 2012).

In the weeks following Facebook’s IPO, the stock continued to fall reaching less than half of its original price by August 2012 (Rodriguez, 2012).

Like LinkedIn, Facebook’s inaccurate price was caused by a combination of factors, not the least of which was the massive technical failure on the part of NASDAQ which delayed trading by nearly 2 hours (Rushe, 2012a).

Although it is possible that the technical difficulties on the part of NASDAQ caused some of the fluctuation in price, many believe that the stock price would have fallen anyway because Facebook was grossly overpriced with a valuation of nearly one-hundred times its 2011 annual earnings (McBride & Gupta, 2012).

This comes as a result of overestimating the future growth of the firm (Kennon, 2012). Leading up to the IPO, Facebook’s projected growth for 2012 was 64%, down from an 88% growth in 2011 (Kennon, 2012). Even assuming a year-over-year growth of 65% for the foreseeable future, this would only bring the value of Facebook’s shares to $24-$25 each (Rushe, 2012b).

Along with an inaccurate estimation of Facebook’s growth prospects, demand for Facebook’s stock was also overvalued. This was caused less by poor diligence during the road show and more by bad timing. In the days leading up to the offering, members of the underwriting team of Morgan Stanley indicated that they would be cutting revenue forecasts for Facebook.

Though thin information is legally not allowed to be published until 40 days after the IPO, Morgan Stanley operated in a legal gray area by providing a verbal preview of the reduced revenue estimates to major investors (Indvik, 2012). Upon hearing this news, investors’ confidence in the stocks began to waver. Then, to much surprise, Facebook increased the number of stocks offered by 25%, sticking investors with even more over-valued shares, causing them to become forced sellers (Osak, 2012).

This resulted a larger than expected sell-off of shares early after the IPO opened for trading and caused other investors to follow suit. It is estimated that 57% of shares sold came from insiders whereas the typical percentage is below 10%.

Ipo valuation using dcf

This flooded the market with shares, driving prices down and costing investors millions (Osak, 2012).

Conclusion

Of the entire complicated IPO process, arguably the most important component is the valuation of the company and the pricing of the stock. To determine an accurate value, a firm can use valuation methods such as the discounted cash flow method or the comparables method to determine an initial value for the firm.

Then, during the remainder of the underwriting process, the underwriting team can determine a best final value by evaluating the sentiment of the market, the state of the industry, and the demand of investors. When the price is set correctly, both investors and the firm making the offering win; however when the price is set either too high or too low, it can spell disaster or create a missed opportunity for the firm.

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Key Components of a DCF

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Ipo valuation using dcf

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