Master How To Value A Company Before Investing in an IPO

Companies go public to raise capital, and the proceeds from the IPO are used by the company either for growth initiatives, expansion of the existing operations, or debt repayment. IPOs provide an opportunity for investors to buy shares of the company deciding to go public and be part of their growth journey from the start. However, before investing in an IPO it is crucial for an investor to evaluate the company’s worth to make an informed decision.

In this article, we will explore how to value a company before investing in an IPO by focusing on key metrics, financial indicators, and practical tips to help you make that informed decision.

What is an IPO and Why Does IPO Valuation Matter?

An IPO, short for an initial public offering, is the process through which a private company raises capital by issuing shares to the public for the first. This way, a private company becomes a public one. Through an IPO, investors can buy the shares of the company even before they start trading on the stock exchange. Unlike publicly traded stocks, IPOs, however, do not possess historical data to showcase their performance on the stock market, thus it makes it difficult to determine their fair market value. Thus, understanding how to value a company can prevent investing in overhyped IPOs that may not perform well after listing.

Key Metrics and Ratios to Value a Company Before Investing in an IPO

To value a company it is important to analyze specific key metrics and financial ratios to determine whether the issue price of the company aligns with its actual worth and growth potential. Here are the key metrics.

Price to Earnings ratio (P/E)

Among the most widely used valuation metrics is the P/E ratio. This ratio helps to determine whether the stock’s price is justified by its earnings. The P/E ratio is simply the price per share divided by earnings per share (EPS). An undervalued stock could be indicated with a lower P/E ratio, while a higher P/E ratio would mean that the stock is relatively more expensive.

For IPOs, however, the P/E ratio needs to be compared with the P/E of listed companies within the same sector.

For Example: In 2021, when ZOMATO launched its IPO its P/E was considered higher than industry averages. This led to the discussion of whether the higher P/E was justified by its future earning potential or was overvalued due to hype surrounding the food and tech industry. As a prospective investor, to get a proper perspective on the P/E ratio you would compare the P/E of ZOMATO with other listed food delivery or tech companies globally.

Price-to-Book (P/B) Ratio

The P/B ratio compares a company’s stock price relative to its book value (assets minus liabilities). The P/B ratio can offer valuable insights especially if the companies belong to the banking or real estate sector as these companies have significant tangible assets. Tangible assets are those assets that are physical, used by the companies in their operations, and are recorded in their balance sheet. A P/B ratio below 1 may indicate that the stock is undervalued, however, for companies with high growth potential or strong brand value, a higher P/B ratio can still be reasonable.

Example: When SBI Cards & Payment Services, launched its IPO, its P/B ratio was slightly higher than the banking sector average. Under such a case an investors had to determine if the company’s brand value, growth potential, and the rapid adoption of digital payment services justified the slightly higher P/E.

Enterprise Value to EBITDA (EV/EBITDA)

The EV/EBITDA ratio compares the company’s total value (EV) to its EBITDA (i.e. Earnings before Interest, Taxes, Depreciation, and Amortization). A lower EV/EBITDA of a company in comparison to its peers from the same industry might indicate that the company is valued cheaply,

For example: When Nykaa went public, it had a relatively higher EV/EBITDA in comparison to other retail and beauty businesses. The decision an investor would have to make whether the higher EV/EBITDA was justified due to Nykaa’s rapid revenue growth, strong position in the market, and profitability in a highly competitive market.

Revenue and Revenue Growth Rate

For IPO valuation, one of the most important indicators that need to be analyzed is revenue growth. High revenue growth usually means there is a demand and acceptance of the product or services offered by the company in the market, which is essential for sustained growth post-listing.

Example: Paytm’s IPO received mixed reviews mainly due to its significant revenue coupled with huge losses.. Even though Paytm was able to register high revenue growth in India’s prospering digital payment space, the company’s failure to clock at least some sort of profit made many investors suspect its valuation. This point highlights the importance of balancing growth with profitability.

Gross and Operating Margins

Gross and operating margins are also indicative of the efficiency with which a company achieves profit from its operations. High gross margins indicate effective control over production costs, while high operating margins reflect overall good management of the costs.

An analysis of the company’s market position and its competitive advantage

The above-mentioned Quantitative indicators only tell part of the story. It is equally important to analyze the company’s market position, competitive advantage, and business model.

Industry Position and Market Trends

To understand the company’s growth potential, knowledge of the industry in which the company is operating is important. Check the demand for the company’s offering in India and around the globe. For example, companies belonging to renewable energy and technology are growing due to the government’s initiatives and increased adoption of technology by consumers,

For example, companies like Adani Green Energy have benefitted due to the government of India’s push towards renewable energy. Similarly, companies like Zomato and Swiggy are growing due to the increasing adoption of technology by consumers.

USP

What is the company’s Unique Selling Proposition (USP), does the company have a competitive moat? A company with a proprietary patent, a brand value, or an exclusive partnership, will make the company stand out from its competition. Thus, giving it an edge over its competitors. On the other hand, a lack of differentiation will make the company vulnerable to competition.

For instance, Dr. Lal PathLabs boasts a strong USP. A brand with high trust levels in diagnostics, with a strong distribution network. These factors increased investor confidence when the company went public.

Scalability of the Business Model

Firms with scalable business models, such as technology and e-commerce, are likely to gain growth post-IPO, thus enhancing shareholder value. Determine whether the company’s products or services can easily be scaled without a corresponding increase in operating costs.

Example: When Info Edge (Naukri.com) went public, its scalable model allowed it to expand without significant additional costs. This made it attractive for investors due to its potential for giving high returns without corresponding increases in costs.

Financial Health Indicators of the Company

Here are some signs of good financial health of a company.

Debt-to-Equity Ratio

What It Is: The ratio shows how much debt the company has compared to its equity (or value owned by shareholders).
How to Use It: A company with lower debt is less risky to invest as compared to a company with a high debt level. Companies with low debt may be more stable, especially during tough economic times.

Example: When Vodafone Idea was formed, its high debt levels were a red flag for investors. Companies with high debt levels may face pressure if interest rates rise or cash flow doesn’t meet expectations.

Cash Flow

What It Is: Cash flow measures the money coming in and going out of the company. Positive cash flow means the company has enough money to manage its day-to-day operations and invest in growth.
How to Use It: Consistent, positive cash flow is a good sign that the company is financially stable.

Example: When Avenue Supermarts (DMart) went public with its IPO it had strong cash flows. This attracted investors, as it indicated that the company could fund its growth and manage operational expenses efficiently.

Profitability Ratios (ROE and ROA)

Return on Equity (ROE): This measures how well a company uses shareholder money to generate profit. A higher ROE generally indicates effective management.
Return on Assets (ROA): This shows how well the company’s assets are being used to generate revenue.

It is important to compare these ratios with other companies within the same sector to get a proper perspective on the company’s operational efficiency.

Review the IPO Prospectus

The IPO prospectus contains all the important information regarding the company. It has the company’s business model, risk factors, how they are planning to spend the capital raised, the future growth strategy, and the potential challenges they might face. Hence, it is very important to read and understand the company’s prospectus.

Conclusion: Value a Company before Investing in an IPO

Investing in an IPO can be rewarding for an investor. However, it is necessary to take the time to understand the company’s valuation, financial health, and growth prospects. Analyse valuation metrics like the P/E, P/B, and other ratios. Also, consider qualitative factors like market position and business model scalability. By following these guidelines, you will be in a better position to make an informed decision and invest wisely in an IPO.

Happy IPO Investing!