Saturday, January 8, 2011

How exactly is an IPO price decided?

I received a query from my friend and reader Ranjit. He has seen lots of IPO coming into the market and is unsure which ones are good and wants to understand this process of fixing the price so as to be able to make an informed decision.

The process of deciding IPO price is generally done by what is known as ‘Book building process’.

Firstly the number of shares to be issued is decided and merchant bankers with book running lead manager appointed.These guys manage the whole show until the company is listed. The lower price end is known as the floor price and investors are expected to at least meet that price in order to make a valid application. Floor price is decided based on various factors like comparison with industry peers, past financial statements, track record of promoters and market sentiment etc. It is in the interest of the company to keep this price rational because if it’s too high investors may not bid for the issue and book building process will fail. This happened to companies like Wockhardt Hospitals,Emmar MGF etc.. The higher end of the range is maximum about 1.2 times the floor price this gives us the price range.

Investors now bid for number as well as price and the highest price(within the range) at which the complete book can be sold is decided as final issue price. For example
Assume that the range is Rs 100 – 120, and only 80% of book can be done at 120 then the price is lowered to the price at which 100% of the shares can be sold. Investors who bid at a higher price are sold at a decided price and refunded the difference and investors who bid lower than the decided price are not allotted any shares and refunded completely.

Reliance Power was an example of a well marketed IPO, the company sold shares without any earnings from operations at the price of about 5 digit P/E and this left a bad taste in the mouth of investors when shares dropped below issue price. The company was forced to give a rights issue to pacify investors since the promoter does not want his reputation to be hurt. Once investor sentiment is hurt it’s very difficult for the company to raise money from the market again.IPO listed when market sentiment was at its peak and people were willing to pay really high prices for stocks but ultimately the market will fall in line with value regardless of marketing gimmicks.

Coal India IPO was an example of well priced IPO this generated lot of interest and made money for the investors. Market respects good companies offered at fair prices. As a investor we must always try to read the ‘red-herring’ prospectus. This contains info about rational for deciding the price and describes the business of the company etc. We should carefully do an evaluation based on quantitative and qualitative factors.

So why do IPO’s fail sometimes?

Promoter’s short term greed is usually the key factor. If a new company comes into the market its price has to be rationally comparable to other listed companies in the same space. If an issue list during situation when market sentiment is driving risk aversion among investors even good issues may not get the attention they deserve.

However once a company lists and begins to perform more people will line up to buy at higher prices thus pushing the price up and making the promoter rich in the process (assuming he is the majority share holder) however we live in a world dominated with fast –foods but junk food does come back to bite you and so will the mis priced IPO.