Solution: Relative valuation using multiples such as P/E (adjusted for leverage, growth rates) and EV/EBITDA are most commonly used for valuing IPOs. To value an IPO, we start with an already listed company and take its trading multiple as base.Then, we make adjustments for information availability, phase in the product development, size and growth rates.
- We need to identify comparable assets and obtain market values for these assets.
- Convert these market values into standardized values, since the absolute prices cannot be compared. This process of standardizing creates price multiples.
- Compare the standardized value or multiple for the asset being analyzed to the standardized values for comparable asset, controlling for any differences between the firms that might affect the multiple, to judge whether the asset is under or overvalued.
You will be surprised to learn that most valuations in the markets are relative valuations and most of the IPOs are valued based on relative valuations.
- Almost 85% of equity research reports are based upon a multiple and comparables.
- More than 50% of all acquisition valuations are based upon multiples
- Rules of thumb based on multiples are not only common but are often the basis for final valuation judgments.
Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when,
- the objective is to sell a security at that price today (as in the case of an IPO)
- investing on “momentum” based strategies
Why Relative Valuation is most preferred for IPOs?
With relative valuation, there will always be a significant proportion of securities that are undervalued and overvalued. Since investment bankers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation, so it makes valuation of IPOs more easier.
The problem with multiples is not in their use but in their abuse. If we can find ways to frame multiples right, we should be able to use them better. The problem with DCF is that it requires more data and DCF is preferred mostly when we want to value assets for long term (more than 5 years), means the investor has a investment time horizon of more than 5 years.