Valuing IPOs

Moonchul Kim ,Jay R. Ritter

Presenter

Abstract
This paper finds that the comparable
firms approach with P/E ratios , M/B
ratios and price-to-sales multiples have
only modest predictive ability without
further adjustment.

Abstract (Cont.)
This paper further indicates that the
accuracy would be improved if we used
forecasted earnings rather than used
historical earnings data.

1. Introduction

The incentive of this paper:

The comparable firms approach is widely
recommended , especially in the IPO firms,
but there has been no systematic study of
the usefulness of this approach.

1. Introduction (Cont.)

The comparable firms approach results in

weak predictive power when we use historical
accounting data without further adjustment.

When forecasted earnings are used for

calculating P/E ratios , the accuracy will
improve substantially.
5

1. Introduction (Cont.)

This is because among publicly-traded

firms in the same industry, P/E ratios
display wide variation that just about any
price can be justified.

1. Introduction (Cont.)

Two sets of sample firms:

(1) Recent IPOs in the same industry
(determined by four-digital SIC codes)
(2) Comparable firms chosen by a
research boutique
( Renaissance Capital ) .
7

1. Introduction (Cont.)

The result indicates that the sample firms

chosen by the research boutique
( Renaissance Capital ) has better predictive
power than the sample firms chosen by
recent IPOs in the same industry.
Multiples using forecasted earnings work
better than those using historical earnings.
8

1. Introduction (Cont.)

Other multiples :
M/B ratios , price-to-sales, enterprise valueto-sales , enterprise value-to-operating cash
flow ratios.

1. Introduction (Cont.)
These ratios are somewhat more accurate than
the use of historical accounting data ,
especially when we make adjustment to reflect
the differences between the profitability and
growth rates of the IPO firms and comparable
firms.

10

1. Introduction (Cont.)

There is a presumption that many IPO firms have valua

growth options whose value is difficult to capture using
one-year-ahead earnings forecasts.

Splitting the sample firms into young and old firms

The valuation errors of the comparable firms
multiples are apparently smaller for the older
firms than for the younger firms, especially using
earnings data.

11

2.Related literature
-Alternative valuation frameworks

Valuation Methods :
(1) Comparable firms approach .
(2) Discounted cash flow approach (DCF) .
(3) Asset-based approach .

12

2.1 Alternative valuation frameworks

Comparable firms approach:

It can use several market multiples
such as P/E ratios , M/B ratios , P/S ratios ,
price-operating earnings ,
enterprise value-to-sales,
enterprise value-to-operating earnings ratios.

13

2.1 Alternative valuation frameworks

( Cont. )
The estimated market price of the IPO firm
= EPS of the IPO firm the average or median
P/E ratios of comparable firms

14

2.1 Alternative valuation frameworks

( Cont. )
The comparable firms approach works best
when a highly comparable group is available,
because it can reduce the probability of
misvaluing a firm relative to others.
Disadvantage:
It provides no safeguard against an entire sector
Being undervalued or overvalued.
15

2.1 Alternative valuation frameworks

( Cont. )
Boatsman and Baskin (1981) compare the
accuracy of two different samples of P/E
models.
Absolute prediction error
= log (predicted price) log (actual price)
16

2.1 Alternative valuation frameworks

( Cont. )
Two different sample firms :
(1) Random firms from the same industry
(2) The firms from the same industry with
the most similar ten-year average
growth rate of earnings better.

17

2.1 Alternative valuation frameworks

( Cont. )
Alord (1992) examines the accuracy
of the P/E ratios valuation method when
comparable firms are selected on the basis of
industry, firm size, and the earnings growth .
The median absolute prediction error is

smaller for selecting comparable firms by industry

(defined by three-digital SIC codes) than selecting
comparable firms by non-industry factors.
18

2.1 Alternative valuation frameworks

( Cont. )
The effect of adjusting earnings for
cross-sectional difference in leverage :
Adjusting earnings for differences in leverage
decreases accuracy, and adding the size factor in
addition to industry membership , it wont improve
the accuracy of the P/E ratio valuation method.
19

2.1 Alternative valuation frameworks

( Cont. )
DCF approach :
The DCF approach is based on a firmer
theoretical basis than any other approach ,
but it is difficult to estimate future cash flows
and an appropriate discounted rate.

20

2.1 Alternative valuation frameworks

( Cont. )
Asset-based approach :
It looks at the underlying value of a companys assets
to indicate the companys value. It is more relevant
when a significant portion of the assets can be
liquidated at a well-determined market price.
Disadvantage:
In most IPOs , the asset-based approach is
inappropriate because most of their value comes
from the future growth opportunities.
21

2.2 Valuation studies in a

non-market setting

The extent of valuation studies in non-market

settings include the determination of an offer
price and management buyouts or leverage buyouts.
It is often assumed that insiders of IPO have better
information than outsiders.

22

2.2 Valuation studies in a

non-market setting ( Cont. )

Ritter (1984) , Kim et al. (1995) , Klein (1996)

, and Van der Goot (1997) find that IPOs with
a larger fraction of the equity retained by
preissue shareholders have higher market
valuation.

23

2.2 Valuation studies in a

non-market setting ( Cont. )

Kaplan and Ruback (1995) examine the DCF

approach by using highly leveraged
transactions , they find that transaction prices
are close to the present value of projected cash
flow, but they are unable to reject the
hypothesis that the projections are made to
justify the price.

24

2.2 Valuation studies in a

non-market setting ( Cont. )

Kaplan and Ruback (1995) report that the

CAPM-based DCF valuation approach has
approximately the same accuracy as the
comparable firms approach.
But their sample firms are large and mature
firms , it is unlike our sample firms which are
going public.
25

2.2 Valuation studies in a

non-market setting ( Cont. )

Gilson et al.(1998) find that , for firms

emerging from bankruptcy , DCF method has
the same accuracy as the comparable firms
approach.

26

3. Data
This paper uses a sample of 190 domestic
operating company IPOs from 1992 to 1993.
Why it restricts sample to 1992 to 1993 IPOs??

27

3. Data(Cont.)
Sample selection criteria:

Universe of firm commitment, nonunit,

nonfinancial domestic operating company
IPOs

832

Exclusion of reverse LBOs and total

divestiture of subsidiaries

164

Remaining

668

Exclusion of IPOs with proceeds < $ 5

million or offer price < $ 5.00

56 28

3. Data(Cont.)
Remaining

612

Exclusion of firms with EPS 0 in the

12 months prior to the offer

194

Remaining

418

Exclusion of firms with preissue book

value 0

48

Remaining

370
29

3. Data(Cont.)
Exclusion of IPOs when there is no IPO
in the same (four-digit) industry in prior
12 months

180

The sample were used in this paper

190

30

3. Data(Cont.)
EPS:
Earnings per share (fully diluted) before
extraordinary items and discontinued
operations for the most recent 12 months
prior to the IPO, adjusted for stock splits.
Sales:
Sales for the last 12 months reported in
the prospectus.
31

3. Data(Cont.)
BPSpreissue:
the book value per share reported in the
prospectus.
BPSpostissue:
the book value per share as adjusted for
the net proceeds and primary shares from
the IPO.
32

3. Data(Cont.)

33

4.1 The Comparable firms approach

Many market multiples can be used in the
comparable firms approach, including
industry-specific ratios.
Amir and Lev (1996) provide a valuation
study of wireless communication industry.
34

4.1 The Comparable firms

approach(Cont.)
Zarowin (1990) shows that long-term
growth is very important in determining
E/P ratios.
Liu and Ziebart (1994) find a significant
relationship between E/P ratios and growth
, dividend payout, and size.
35

4.1 The Comparable firms

approach(Cont.)
Ohlsons (1995) model shows that the M/B
ratio is a function of the firms abnormal
earnings generating power and thus
reflects the firms growth potential.

36

4.1 The Comparable firms

approach(Cont.)
This paper uses two groups of firms for
the comparables:
1. recent IPOs
2. firms chosen by a research boutique

37

4.1 The Comparable firms

approach(Cont.)
When we use recent IPOs as comparable
firms using an algorithm that does not
necessarily pick the best comparable firms
that a practitioner would choose.
The advantage and disadvantage of the
algorithm??
38

4.1 The Comparable firms

approach(Cont.)
Using price-earnings ratios, the comparable
firms approach for empirical analysis is
expressed as:

P / Ei a0 a1 P / E comp , i ei

39

4.1 The Comparable firms

approach(Cont.)
Using market-to-book ratios, the comparable
firms approach for empirical analysis is
expressed as:

M / B postissue ,i a0 a1 M / B comp ,i ei

40

4.1 The Comparable firms

approach(Cont.)
Using price-to-sales ratios, the comparable
firms approach for empirical analysis is
expressed as:

P / S i a0 a1 P / S comp ,i ei

41

4.1 The Comparable firms

approach(Cont.)
We also use a simple multiple approach,
in which the predicted multiple of the IPO
is simply the mean or median of the
multiples of the comparable firms.

42

4.1 The Comparable firms

approach(Cont.)
Figure 1 illustrates the logic of using
comparable firm multiples and the reality.

43

4.1 The Comparable firms

approach(Cont.)

44

4.2 Recent IPOs as comparable firms

Comparable firms:
1.Firms that go public no more than 12
months prior to the IPOs offer date.
2.Firms with the same four-digit SIC codes.
3.Five IPOs with the closest last 12 months
sales are selected.
45

4.2 Recent IPOs as comparable firms

46

4.2 Recent IPOs as comparable firms

We use the EPS, book value, and sales
numbers from the prospectuses instead of
those available from more recent financial
statements.
Why?
47

4.2 Recent IPOs as comparable firms

Newly public firms usually use the
proceeds of the offering repay debt, invest
in their business, and put the balance in
money market instruments.
Interest income generated in this case is
unlikely to reflect the firm's future growth
potential.
48

4.2 Recent IPOs as comparable firms

P/E: Price/Pre-IPO Earnings
M/B: Market value/ Postissue book values
P/S: Price/ Sales
Price:IPO firm--offer price
Comparable firms--market price on the
day before issuing

49

4.2 Recent IPOs as comparable firms

50

4.2 Recent IPOs as comparable firms

Prediction errors =
ln (median comparables multiple)
- ln (IPO multiple)

The percentage of predicted valuations within

15% of the actual multiple =
log (predicted) log (actual) < 0.15
51

4.2 Recent IPOs as comparable firms

52

4.3.OLS Regression
P / Ei a0 a1 P / E comp ,i ei

M / B postissue ,i a0 a1 M / B comp ,i ei

P / Si a0 a1 P / S comp , i ei

Dependent variables: IPO firms multiple

Explanatory variables: comparable firms multiples
The null hypothesis: a1 = 1
53

4.3.OLS Regression

54

4.3.OLS Regression
The possible reason for a1 < 1:
If the explanatory variable is measured with error,
then a1 has an expected value of 1/(1+e2/x2)

where
1 = true slope coefficient
e = the standard deviation of the measurement error
x = the standard deviation of the true explanatory
55
variable

4.3.OLS Regression
The performance of the comparable firms
approach is surprisingly weak.
1.Past accounting data for a young firm may
not reflect expectations of the firm's future
performance.
56

4.3.OLS Regression
The performance of the comparable firms
approach is surprisingly weak.
2.Using comparable firm multiples without
further adjustments for differences in
profitability and growth may ignore too
much relevant information.
3.The comparable firms may have been
chosen inappropriately.
57

4.4 The relative importance of multiples at

different stage of the offering

We use three separate prices to compute the

market value of equity.
1.POP:the midpoint of the minimum and
maximum offer prices from the
preliminary prospectus.
2. OP : final offer price
3.Pmarket:the first market price
58

4.4 The relative importance of multiples at

different stage of the offering
Preliminary
offer price
range (POP)

Final offer
price
(OP)

First market
price
(Pmarket)

Comparable
firms market
multiples

Additional
information:
market demand

First day
closing
price
59

4.4 The relative importance of multiples at

different stage of the offering

P/Ei = a0 +a1 P/Ecomp,i + ei

The following relation is expected to hold:
AVEPOP < AVEOP < AVEmarket
where AVE = log (predicted multiple)
- log (actual multiple)
= the average absolute valuation
error
60

4.4 The relative importance of multiples at

different stage of the offering

61

5. Valuation using earnings

forecasts and comparables
from Renaissance Capital

Picking comparable firms with

Renaissance Capital research reports,
not with the same SIC codes.
62

Whats the Renaissance

Capital ?
A boutique firm specializing in IPO
research.
It lists the street estimate for current
fiscal year, next year, and the latest 12
months EPS numbers for IPO and two
comparable firms.

63

How to calculate P/E ratios ?

For IPO firms:

P: offer price
E: last 12 months
current fiscal years forecast
next years forecast

64

How to calculate P/E ratio ?

For comparable firms:

P: closing market price of the stock
on the day before the report is
issued.
E: last 12 months
current fiscal years forecast
next years forecast
65

Whats the difference between the

Renaissance Capital and the same
SIC codes for comparable firms?

Based upon firms mentioned in the

prospectus as the major competitors of
the firm going public, not restrict itself to
companies with the same SIC codes.
66

The data information

Size: 143 IPOs
Sample period: September 1992 to
December 1993
IPOs evaluations are available from
RC, and comparable firm multiples
are available from Compuatat
Dow Jones: < 4000

67

5.2. Valuations using

forecasted earnings, and for
young and old firms
Explanatory variable:
geometric mean of the RC comparables
firm P/E multiples
Dependent variable:
three P/E ratios of IPOs
68

Why use geometric mean ?

puts less weight on extreme values
For example:
4 and 46
4*16 = 13.56 geometric mean
(4+46)/2=25 .midpoint

69

Whats the assumptions ?

If one of comparables has a negative
EPS, then use another one.
All IPOs and comparables midpoint
P/E ratios to be no greater than 100.

70

Some information of the Table 6

RC does not cover small IPOs for which
there is little institutional interest.
The mean gross proceeds of the sample
is $45.4 million, with the range of $11.3
million to $299.3 million, exclusive of
overallotment options.
All reverse leveraged buyouts are
excluded.

71

72

Note:
The street earnings forecasts for the
IPOs are typically provided by analysts
who are affiliated with investment
bankers, so there may be a conflict of
interest.

73

74

Why the slope coefficients are

below 1 and the R2s are below
100%?
difference growth rates
The standard growing perpetuity
valuation model:

EPS1
P0
rg
75

76

Rapidly growing firms going

public may be view by the
market as having transitory
component in their earings.
77

78

5.3 Valuations using multiples

that invariant to leverage
Why doesnt Renaissance Capital choose
M/B ratio?
Other multiples:
price-to-sales
enterprise value to operating cash flow
enterprise value to sales

79

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Table7:(please turn to page 432)
In Panel A: price-to-sales ratio

MV
MV
MV
i 0 1
i 2 DUMMY fastgrowth
i ei
Sales
Sales
Sales

In panel B: use enterprise value-to-sales ration

EV
EV
EV
i 0 1
i 2 DUMMY fastgrowth
i ei
Sales
Sales
Sales

In panel C: enterprise value-to-operating cash flow

EV
EV
EV
i 0 1
i 2 DUMMY fastgrowth
i e80i
OCF
OCF
OCF

5.3 Valuations using multiples

that invariant to leverage(Cont.)

Dummy
variable

=1,if the sales of the IPO are

growing faster than the
midpoint of the comparable
firms growth rate.
=0, otherwise
81

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Definition:
I. Sales of IPO and Comparables are the last 12
months sales.
II. Operating Cash flows of IPO and Comparables
are defined as EBITDA for the last 12 months.
82

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Definition:
III. Price of IPO = pro forma of shares times
the midpoint of the offering price range.
IV. Enterprise value of IPO = MV + pro forma
book value of debt pro forma cash.
83

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Definition:
V. Price of Comparable firm is computed the
market price at the time that IPO is valued.
VI.Enterprise value of Comparable firm is
computed using accounting information and
market price at the time that IPO is valued.
84

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Definition:
VII. Comparable multiple is computed as the
geometric mean of the multiples for the two
comparable firm.

85

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Table 7

Table 6
Absolute Prediction errors

Absolute Prediction errors

Mean(%)

P/S:(1)

Mean(%)

56

(1)12-month historical

55

EV/Sales:(5)

52.8

(1)12-month historical

55

EV/OCF:(9)

43.2

(2)Current year forecast

43.7

86

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Table8:
EV
EV
EV
EV
i 0 1
i 2 PROFITABIL ITY
i 3 DUMMY fastgrowth
i ei
Sales
Sales
Sales
Sales

=1,if the percentage increase in sales in

the prior year of the IPO is > the
PROFITmidpoint of the percentage increase
ABILITY
in sales for each of the two
comparable firms.
87
=0, otherwise

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Table 8

Table 7
Absolute Prediction errors

Absolute Prediction errors

Mean(%)

Mean(%)

(1)

50.3

Panel B:(5)

52.8

(2)

48.8

(6)

52.1

(3)

48.5

(7)

50.4

(4)

38.2

(8)

51.6

88

5.3 Valuations using multiples

that invariant to leverage(Cont.)
Table 8
Parameter estimates
Profitability
multiple

(2)

0.218
(4.18)

D fastgrowth
multiple

0.199
(2.90)

89

6. Conclusions

First, P/E vs. EV/sales and EV/OCF

If earnings are the historical numbers, and
then EV/Sale and EV/OCF would be more
accurate than P/E.
If earnings are the forecast numbers, and
then using P/E is similar to EV/sales and
EV/OCF to evaluate IPO price.
90

6. Conclusions(Cont.)

Secondly, boutique works better than

recent IPO.
Table 4:recent IPO

R
P/E

2
adj

5.0

Table 6:boutique

Absolute Prediction errors

Mean(%)

56.5

(1)

2
adj

8.3

Absolute Prediction errors

Mean(%)

52.8
91

6. Conclusions(Cont.)

Thirdly, the authors also find out

The valuation accuracy is higher for
older firms than young firms.
Table 7

Table 6

Table 8

Absolute Prediction errors

Absolute Prediction errors

Absolute Prediction errors

Mean(%)

Mean(%)

Mean(%)

Young

31.9

Young

48.2

Young

48.5

Old

23

Old

28.2

Old

38.2
92

6. Conclusions(Cont.)

Finally, additional adjustments can more

improve the valuation accuracy.
And the magnitude of adjustments is
consistent with the industry practice.

93

THE END
94