Executive Summary
-
When a company goes public, the issuer’s intermediating investment bank (aka the underwriter, bookrunner, or lead manager) expends efforts and resources to discover the price at which the firm’s shares can be sold.
-
Buy-side clients also expend effort and resources to value the firm. The market price will be a weighted average of the many resulting value estimates.
-
To discover the price at which the issue can be sold, the issuer helps buy-side clients with their analysis by providing a prospectus and meeting with their analysts during road show meetings.
-
To extract newly produced information from the market, the issuing team asks selected buy-side clients for their indications of their interest.
-
Investment banks compensate buy-side clients for their costly analysis by setting the price at a discount from the expected market price.
-
In addition, investment banks allocate more shares to those buy-side clients who are more helpful in the price discovery exercise. Because of the repeated interaction between banks and their clients, free riding is curtailed, and price discovery is optimized.
Price Discovery
The most important, yet most difficult, part of the initial public offering (IPO) process is setting the offer price. In an IPO, the issuer, aided by an intermediating investment bank, plans to sell a relatively large number of shares of common stock in which there is at that point no market. However, they know that soon after the IPO process the secondary market will impute all the information in the market in an efficient manner. Investors who believe the price to be too high will sell; investors who believe the price to be too low will buy. The key outcome of this competitive trading is the market price of the stock.
Naturally, the issuing team (the issuer and its investment bank would like to know the market price in advance. If they had a crystal ball, they would set the price at a small discount (say 3%) to the future market price, so as to generate sufficient interest from buy-side clients, and place the issue. In fact this is exactly what issuers do when they sell securities which already have a market price. Unfortunately, there is no secondary market for IPO shares, and neither are there crystal balls.
To estimate the market price as best as they can, issuers and their advisers conduct a costly analysis to estimate the value of the firm. We call this process price discovery.
Note that not only do the issuer and its investment bank analyze the firm. Prospective investors also conduct costly analysis to predict the future market price. Naturally, a good estimate of the future market price gives them a substantial advantage in their dealings with the issuer: If they have strong indications that the offer price is set too high, they stay away from the offering. If they believe the price to be below the future market price, they sign up for IPO shares enthusiastically.
Enterprise Valuation
There are two main methods to estimate the market value of the firm: multiple analysis, and discounted cash flow (DCF) analysis.
Multiple Analysis
When employing the multiple method, analysts gather performance measures of the firm. A popular measure is earnings or net income. They multiply these performance measures with multiples. The appropriate multiple for a firm’s earnings is the price–earnings ratio, or P/E. The multiples are obtained from similar firms, (so-called proxies, or pure-plays). For example, if listed paper manufacturers trade at an average P/E of 9, and we want to estimate the value of an unlisted paper company that recently reported a net income of $1 million, we would estimate the market price to be $9 million. Because this single estimate is bound to be imprecise, analysts collect many performance measures so as to get many estimates. Popular accounting performance measures are earnings, sales, operating income (EBIT), and cash flow (EBITDA). Apart from these, analysts use industry-specific performance measures such as passenger miles (for airlines), overnight stays (for hotels), or page visits (for internet companies). By employing more and more multiples, analysts aim to arrive at an ever more precise estimate of the market price.
Discounted Cash Flow Analysis
A more fundamental valuation method is discounted cash flow analysis. In an efficient market, securities should be worth the present value of the future cash payments that accrue to the shareholders. Since cash today is always more valuable than cash tomorrow, investors discount projected future cash flows at the opportunity cost of capital. For example, if investors want to value a one-year promissory note of $100, and the one-year interest rate is 10%, they conclude that the note is worth $100/1.10 = $90.91. If future cash flows are uncertain (risky), investors use a higher discount rate (see p. 896 to see how the discount rate depends on risk).
Apart from deciding on an appropriate discount rate, investment analysts forecast the company’s free cash flows, which are defined as the cash generated by operations less the cash dedicated to new investments. Often, young companies do not distribute cash flows to their financiers, but instead solicit cash from the financial markets. In fact, this is an important reason for doing an IPO in the first place. Naturally, the investments are expected to add to the future cash flows. Hence, analysts often predict negative free cash flows early in life, but expect them to become positive as the firm matures.
Forecasting a firm’s free cash flows is difficult. To obtain reasonable conjectures, analysts make a model to project the revenues, expenses, and investments. Analysts’ models can be very sophisticated. They analyze the products or services that the company provides, conduct industry analysis to gauge where the company stands vis-à-vis its competitors, consult market forecasts (of the firm’s products and production costs), interview the firm’s executives and other employees (as far as this is allowed by the laws that govern financial markets), and conduct sensitivity analysis.
Whatever method investment analysts use to estimate the market value of as yet untraded securities, valuing financial securities is a task that requires skill and effort.
Estimates Are Often Wrong
Being an investment analyst does not just require hard work, it is also a risky job. After all, despite our best efforts, estimates often turn out to be wrong. That is the nature of estimates.
Each valuation is different. Analysts use different multiples, different proxies, and give different weights to individual multiple estimates. DCF valuations are highly sensitive to the many assumptions incorporated into a model, and to the discount rate used to arrive at a present value. Clearly, if we have many independent estimates, the highest estimate is likely to be too high and the lowest estimate is probably too low. If we assume that the estimates are unbiased, the true market value will lie somewhere in the middle.
Hence, there are two ways to engage in price discovery. The first is to help analysts to make more precise estimates. To do this, the issuer and its intermediaries (investment bank, auditor, legal advisers) provide buy-side analysts with a detailed prospectus, which explains the structure of the issue (for example, how many shares are sold), describes the company’s business, and presents recent financial performance. In addition, they invite analysts to information sessions on the firm’s products and managers. During such road-show presentations, the company presents its business plan, its managers, and its products to prospective investors. An important part of the road-show meetings is the question and answer session, during which analysts can pepper the issuing team with questions so as to fine-tune their models and estimates.
The second way to improve the price discovery is to involve more buy-side clients and more analysts. A statistical property called the law of large numbers says that if we have more estimates, the average of these will be closer to the true value. The problem, however, is that if we invite too many prospective investors, it will adversely affect the incentives to produce information.
Sounding Out the Market
When buy-side clients have done their analysis and have become “informed,” issuers will find it easier to sell them their securities. However, there are still important differences in opinion among clients. Extracting these opinions is not an easy task. Clearly, buy-side clients will be reluctant to part with their hard-earned information. Nevertheless, issuers can sound out the market by individually targeting large and well-informed buy-side clients. They do this by ringing them up, and asking them for their opinions and indications of interest. The investment bank writes down indicative orders in a book of orders. This exercise is called book-building. Indicative orders can take three main forms. First there are strike orders, which indicate a demand that is independent of the price. Second, there are limit orders, such as “I sign up for 150,000 shares as long as the price is not higher than $10.” Finally, there are step orders, which are combinations of several limit orders. For example, “If the price is set at $9 or below, we want 130,000 shares; if it is set at $10 or less, we want 80,000 shares; and if you set it higher, we don’t want any shares.”
After one or two weeks of making phone calls, the bookrunner will have compiled a book of orders, which forms a downward sloping demand curve (see Figure 1). Naturally, this demand curve represents very valuable information for the price discovery process.
Setting the Price
One would think that the issuing team can now simply set the price so that demand equals supply. If all orders were genuine, this would be the optimal strategy. However, the new shareholders would feel fooled if, after expending significant efforts to analyze the firm, they received no surplus in return. To reward large and sophisticated buy-side clients for their analysis of the firm, investment banks set the offer price at a discount from the expected market price. Historically, the average discount, which translates into an average initial return (the return from the offer price to the market price) has been around 15%. Initial returns have been extensively studied. Average discounts differ between countries and time periods. All studies, however, find that smaller and more difficult to value IPO firms tend to be discounted more, which is consistent with the “compensation for analysis efforts” story.
The promise of a discount can be made credible because of the investment bank’s reputation and its repeated interaction with the market’s buy-side. For example, because Fidelity knows that Goldman Sachs will price IPO shares at a reasonable discount, they are willing to expend effort to analyze the IPO firm.
The problem with setting the offer price at a discount is that it attracts “free riders.” It seems that investors who simply signed up for all IPOs would, on average, make a profit because of the discount. For this reason, investment banks only invite large and sophisticated investors to submit orders in the book. From experience and repeated interaction, investment bankers know whose indicative orders are most informative. Still, even among the invited bidders there is a temptation to overbid. Because they know that the shares will be set at a discount, buy-side clients want to bid for as many shares as possible. In other words, even the orders of the repeat clients may not be entirely genuine. An important task for the investment bank is to distinguish the real demand from the book demand (Figure 1). They can never do this perfectly, but, through skill and judgment, experienced bookrunners can assess the seriousness of book orders. So, after closing the book, the issuer compiles the book demand curve, gauges where the real demand is, and then sets the price at a small discount.
The price is set during the pricing meeting, which typically takes place on the evening before the actual floatation. During the pricing meeting the issue is officially underwritten, so that the bookrunner becomes legally liable for placing the shares. By scheduling this important meeting shortly before the actual selling day, the bookrunner reduces the risk of being stuck with IPO shares on its books. In the example of Figure 1, the issuers may set the price at $9.50, so as to place all the shares, and leave some money on the table for the buy side analysts.
Allocating the Shares
As mentioned, the IPO process is a repeated game for buy-side clients and investment banks. Both parties to the price discovery process develop long-term relationships. Investment bankers know which buy-side analysts provide the most accurate indications of interest, and reward them with higher allocations. One way to gauge the quality of the buy-side analysts is to monitor their order submission strategy and their trading behavior after the IPO. Strike orders may indicate poor analysis, while limit or step orders are better signals for price discovery. If a client often asks for large allocations, but then quickly sells (“flips”) its shares in the secondary market, this is an indication of poor analysis. Orders that are submitted in the early stage of the book-building indicate confidence and informed decision-making. Hence, it is not surprising that we see that clients who put in limit or step orders early, and do not flip their shares in the secondary market, receive higher allocations on average.
The Over-Allotment Option
Almost all IPOs have an over-allotment option, also known as a greenshoe, named after the company that first used this mechanism. The over-allotment option gives the bookrunner the right to buy a specified number of additional shares from the issuer and sell them on to the buy-side. Or, they have the right to over-allocate. Typically, the option is for 15% of the offering size. In practice, the underwriter always over-allocates, so that after the offering the bank is technically “short”: they have sold shares they do not yet own. The bookrunner will exercise the over-allotment option if the price in secondary market trading increases beyond the offering price, which is usually the case. If, however, the price in the secondary market comes under pressure (i.e. there is a lot of flipping), the underwriter buys back the shares in the open market.
This is sometimes referred to as price support or price stabilization. The over-allotment option is therefore a clever way to adjust the supply of shares to the uncertain demand for shares. By keeping track of flippers, bookrunners can monitor buy-side clients and gauge their quality for the price discovery process.
Book-Building versus Auctions
The book-building mechanism has become the standard way of selling shares in initial public offerings. The characteristic difference from other IPO mechanisms is the close and personal interaction between relatively few players on both sides of the transaction. These cozy relationships, and the subsequent preferential allocations, sometimes make small investors, issuers, and regulators uneasy about the book-building mechanism. Naturally there is the chance that investment banks and buy-side clients collude to set the offer price low and share the profits of large initial returns. Although there certainly have been instances of doubtful allocations of conspicuously underpriced shares, the book-building mechanism has survived and is widely accepted. The key advantage is that it results in more information production.
An obvious alternative to book-building is the auction. Due to its fair and transparent nature, the auction mechanism has been used in several countries, including the United Kingdom, Denmark, and France. However, evidence shows that they are less effective in achieving a high price and a liquid aftermarket. Empirical studies have found that book-built IPOs have, on average, lower initial returns, especially if they were floated by prestigious investment banks.
The Google IPO and a stylized example (see Case Studies) further illustrate how targeted information exchange between relatively few informed players may be more effective for price discovery than an impersonal auction.
Case Studies
The Google IPO
When Google went public in August 2004, it announced upfront that the price would be determined by a competitive Dutch auction in which everybody could participate on equal terms. Large and small investors were invited to submit their limit and step orders through the internet. The price would be set at the point where the 19.6 million shares could be sold. Large institutional investors openly grumbled and complained about the “cheap” way in which Google was selling its shares, saying that they would not bother to get out of bed for an auction.
The result was that, due to the lack of a targeted information exchange, the market price was not fully discovered. The auctioneers set the offer price at $85. When secondary market trading began, the price shot to above $100 within days, and above $200 within months, which suggested that Google did not get the full value for its shares. Many industry watchers (and the author of this article) believe that if Google had opted for a standard book building method, its shares may have fetched a higher price in the primary market.
Illustration of Targeted Information Exchange
Imagine that you receive a surprise inheritance from a distant uncle. The inheritance is a trunk full of foreign coins. Most are post-war coins from various countries, but your seven-year-old son has spotted some gold, silver, and very ancient coins. You are not much of a coin collector and are strapped for cash, so you decide to sell the coins. To do this you go to a coin collectors’ fair. At the fair there is an auction session where you can put your coins up for sale. Alternatively, you can approach the three largest collectors, let each have a close look at your collection, explain your situation, and ask them for their offer. If your collection is difficult to value (as a company is), the second route may well get you a higher price.
www.qfinance.com