Initial public offerings (IPOs) are unique financial assets compared to other stocks.

Because the companies issuing IPOs have not been around long, you have a limited company history to review. Plus, they haven’t been traded before on a public exchange so there is no trading history to analyze.

For regular stocks, pricing these assets follow the basic laws of economics. The value is determined by the forces of supply and demand. New stocks that are issued also follow supply and demand. They sell at a price another person is willing to pay. Top stock analysts who perform stock evaluation will determine what a stock is worth, then capitalize on the situation if the company is trading at a value lower than their analysis. If the company value is trading at a lower value to what it’s worth, then they will purchase shares.

However, because of the limited history of IPOs, to determine the value of an IPO you must use a different method. Some believe IPOs are riskier than older stocks because they have not yet been analyzed. Other think the absence of a historical share price presents a buying opportunity.

In any case, the special nature of IPOs requires different methods to analyze the value of an IPO.

What does IPO valuation mean?

An IPO valuation is the process of figuring out the fair value of a company’s shares. This is performed by an analyst familiar with the overall market and the IPO process. A private company often only considers an IPO when the market demand for their shares is high.

To have a IPO hit it big, there must be buyer demand for the company’s shares. Strong demand leads to a higher prices. In addition to market demand, there are several other components that are factors in IPO valuation, including industry comparables, growth prospects, and the story of a company.

Let’s take a brief look at each.

Demand – Strong demand in the market does not necessarily mean the company is more valuable. It does mean that there’s a chance the company will have a higher valuation. An IPO valuation is the process by which an analyst determines the fair value of a company’s shares.

You will sometimes see two otherwise identical companies have vastly different IPO valuations simply because of market demand and the IPO timing. The best example of this is during the tech boom of the 90s. At the top of the tech bubble, many technology companies had oversized,massive IPO valuations. Compared to later tech IPOs, they had higher valuations, and therefore received much more investment capital. This was due to the fact that market demand was abnormally high in the early 2000s and it did not mean that those companies were better than the ones that came later.

Industry Comparables – If the company operates in an industry with other publicly-traded companies, you see that the IPO valuation includes a comparison of the valuation multiples that are given to the other industry companies. The belief is investors should be willing to pay similar prices for a new entrant into the industry as the prices for existing companies.

Growth Prospects – An IPO valuation also varies on the growth projections of the company. Since the capital raised through the IPO will fund growth, the sale of an IPO depends on the company’s projections and future growth plans.

A Compelling Origin Story – Many of the factors in IPO valuation involve data and analysis. But there is one exception. The company’s origin story can be a powerful driver of success. A valuation process may evaluate the innovation the company is offering, as well as if their new product or a service will revolutionize an industry. The 1990s provide another good example here. Because the tech companies of the 1990s were new and cutting-edge at the time, they were given valuations of several billions of dollars, in spite of the fact that some of them were only a few months old and operating at a loss.

In some cases, the actual business fundamentals can be influenced by the marketing of the company. This is one reason why some companies add industry veterans to their team. They want to appear like they are a growing business with an experienced management team. This is why it is critical for all investors to review the financials of a company and understand the risks of investing in a company without an operating history.

Subhead – How is IPO price determined?

Media and analysts sometimes use the public offering price (POP) to compare the company current stock price. If the share price goes up over its public offering price, then the company is said to be performing well. If the share price drops lower than the initial public offering price, then this is considered a sign that the market has lost confidence in the value of the company.

A public offering price does not always match what the value of the shares. Investors can sometimes get into a buying frenzy and push prices higher than the company is worth. To avoid this, use the balance sheet information the prospectus, to do your own due diligence and calculate the share value on your own, so you can determine if the market is pricing the IPO correctly.

Questions For Analyzing IPOs

If you’re an investor who isn’t buying new issues from an IPO, you can still make money, but you will need to analyze the company. Here are some things to consider when evaluating a new IPO to buy.

What is the reason that the company is going public?
How will the money raised by the IPO be used?
What is the current industry like?
Who are the competitors to this company?
How does the company compare to these competitors?

What is the growth plan of the company?
Who is the management team?
What is the background of the leaders of the company?
What is the past operating success of the business before the IPO?

Where do you find this information to get answers on an IPO?

These question, and much more information, can be found online in public databases and from the company’s Form S-1. After carefully reviewing the company history and the S-1, you will have an solid understanding of the business and its operations. With this information, you can analyze the company and figure out a reasonable valuation for the IPO. You can also use the other valuation strategies discussed in this article to decide if the IPO price is justified or not.

Final and Wrap Up

There are pros and cons to investing in IPOs. Be sure to follow the information in this to begin your own analysis to determine the accurate IPO valuation. And be sure to consult a professional financial advisor for additional advice to answer any further questions you may have.

If an IPO takes off, it can bring you an oversized returns. Investors who got in early on the IPOs of Amazon, Facebook, and Google are likely millionaires today.

Today, there are many IPOs launched each year, so you can use the information in this article to determine the valuation of the ones that you are interested in. The techniques in this article will allow you to do your own due diligence and possibly uncover the next big IPO winner.