Why IPO Valuation Matters
Valuation determines whether an IPO is attractively priced or overpriced. Even a great company can be a poor investment if bought at an excessive price. Understanding valuation methods helps you make informed decisions and avoid overpaying.
Key Valuation Methods
1. Price-to-Earnings (P/E) Ratio
The most common and easily understood valuation method.
Formula
P/E Ratio = Issue Price / Earnings Per Share (EPS)
How to Use
- Calculate IPO P/E using the issue price and last year's EPS
- Compare with listed peers' P/E ratios
- Consider growth rates when comparing
Example
If IPO price is ₹500 and EPS is ₹25:
P/E = 500/25 = 20x
If peers trade at 15x, the IPO is at a premium. But if IPO company is growing faster, some premium may be justified.
Limitations
- Doesn't work for loss-making companies
- Can be manipulated through accounting
- Ignores debt levels
2. EV/EBITDA
Enterprise Value to EBITDA - useful for comparing companies with different capital structures.
Formulas
- Enterprise Value (EV) = Market Cap + Debt - Cash
- EBITDA = Earnings Before Interest, Tax, Depreciation & Amortization
- EV/EBITDA = Enterprise Value / EBITDA
For IPO
Market Cap at IPO = Issue Price × Total Shares Outstanding
Advantages
- Works better for capital-intensive businesses
- Accounts for debt (unlike P/E)
- Less affected by accounting policies
Typical Ranges
- Low: 5-8x (cyclical industries, low growth)
- Medium: 8-15x (stable businesses)
- High: 15-25x+ (high growth tech/consumer)
3. Price-to-Book (P/B) Ratio
Compares market price to book value of equity.
Formula
P/B = Issue Price / Book Value Per Share
Where It's Useful
- Banks and financial institutions
- Asset-heavy companies
- Companies with significant real estate
Interpretation
- P/B < 1: Stock trades below book value (could be undervalued or troubled)
- P/B 1-3: Reasonable for most companies
- P/B > 3: Premium valuation, needs justification
4. Price-to-Sales (P/S) Ratio
Useful for loss-making or early-stage companies.
Formula
P/S = Issue Price / Sales Per Share
OR Market Cap / Total Revenue
When to Use
- Startups and new-age tech companies
- Companies not yet profitable
- Industries where revenue matters more than current profits
Typical Ranges
- Traditional businesses: 1-3x
- Tech/growth companies: 5-15x+
5. Discounted Cash Flow (DCF)
The most fundamental valuation method, though complex.
Concept
Value = Present value of all future cash flows
Steps (Simplified)
- Project future free cash flows (5-10 years)
- Calculate terminal value beyond projection period
- Discount all cash flows to present using appropriate discount rate
- Sum of present values = Intrinsic value
Challenges for IPOs
- Limited historical data for projections
- Highly sensitive to assumptions
- Requires advanced financial modeling
Comparable Company Analysis
The most practical approach for retail investors.
Steps
- Identify Peers: Same industry, similar size, similar business model
- Calculate Peer Multiples: P/E, EV/EBITDA, P/S for each peer
- Find Average/Median: Central tendency of peer valuations
- Compare IPO: Is IPO trading at premium or discount?
- Justify Difference: Any difference should be explainable
Example Analysis
| Company | P/E | EV/EBITDA | Revenue Growth |
|---|---|---|---|
| Listed Peer A | 25x | 12x | 15% |
| Listed Peer B | 20x | 10x | 12% |
| Listed Peer C | 22x | 11x | 18% |
| Peer Average | 22x | 11x | 15% |
| IPO Company | 28x | 14x | 25% |
IPO is at premium (28x vs 22x average), but has higher growth (25% vs 15%). Premium may be justified.
Valuation Red Flags
- P/E significantly higher than all peers without clear reason
- Valuation justified only by "future potential"
- Comparisons to unrelated or foreign companies
- Cherry-picked peer set in prospectus
- Revenue multiple for profitable company (hiding something?)
Industry-Specific Considerations
Technology/SaaS
- Revenue multiples often used
- Look at ARR (Annual Recurring Revenue) growth
- Customer retention metrics matter
Financial Services
- P/B is primary metric
- Consider ROE and asset quality
- NBFCs typically trade at 2-4x book
Manufacturing
- EV/EBITDA appropriate
- Consider capacity utilization
- Asset replacement value matters
Practical Tips
- Use multiple valuation methods, not just one
- Always compare with listed peers
- Adjust for growth rate differences
- Be skeptical of very high valuations
- Remember: valuation is art, not exact science
Conclusion
Valuation is crucial for determining if an IPO offers good value. While no single method is perfect, using multiple approaches and comparing with listed peers provides a reasonable assessment. Remember that even at fair valuations, other factors like business quality and growth prospects matter. Don't let attractive valuations blind you to fundamental problems.