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Executive Summary
When a company goes public, the issuers intermediating investment bank (aka the underwriter,
bookrunner, or lead manager) expends efforts and resources to discover the price at which the firms
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 firms earnings is the priceearnings 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,
Price Discovery in IPOs
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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.
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Figure 1. Example of an order book. During book-building, the lead manager calls up prospective buyside clients and asks them for indicative orders. This results in an aggregate demand curve. However, the
bookrunner knows that not all indications of interest are equally sincere, and he or she has to gauge what
the real demand isi.e. the demand that is not due to strategic overbidding (due to anticipated rationing).
Notice that the real demand is invisible. Investment bankers use their experience and judgment to estimate it
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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.
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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.
More Info
Books:
Draho, Jason. The IPO Decision: Why and How Companies Go Public. Cheltenham, UK: Edward Elgar
Publishing, 2006.
Gregoriou, Greg N. Initial Public Offerings: An International Perspective. Oxford: ButterworthHeinemann, 2006.
Article:
Benveniste, Lawrence M., and Walid Y. Busaba. Bookbuilding versus fixed price: An analysis of
competing strategies for marketing IPOs. Journal of Financial and Quantitative Analysis 32:4 (1997):
383403. Online at: dx.doi.org/10.2307/2331230
Websites:
See Also
Best Practice
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Acquiring a Secondary Listing, or Cross-Listing
J. P. Morgan
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