Investing in a company's IPO presents an opportunity to diversify your investment portfolio. An IPO, or Initial Public Offering, constitutes a company's initiative to raise funds by issuing common shares to finance its investments. Notably, an IPO signifies the initial occasion a company offers its shares to the public.
How does this process unfold? Essentially, the company issues shares and subsequently sells them in the market.
Is it as straightforward as it sounds? Not quite—this process entails complexities.
Table of Contents
- IPO Investing: From Preparation to Prosperity
- Common Shareholder Rights: Essential IPO Knowledge
- IPO Share Price Valuation: Methods Demystified
- Demystifying IPO Share Accounting: What Investors Need to Know
- IPO Investing: Weighing the Pros and Cons
- IPO Investing: Conclusion for Informed Decision Making
IPO Investing: From Preparation to Prosperity
Before delving into purchasing IPO shares, it's crucial to grasp the process behind the company's initial public offering.
Understanding this process is essential because it helps you realize that IPO shares typically entail lower risk compared to investing in non-public companies. This is because the process before a company can sell publicly involves numerous screenings.
So, what exactly is an initial public offering (IPO)? It's when a company offers its shares to the public for the first time.
But what if it's not the first time?
If it's not the first time a company sells its shares publicly, the subsequent share offering process is termed a rights issue.
However, for the focus here, let's concentrate on IPOs, not rights issues.
To prepare for an IPO, as outlined by mnacommunity[1], a company must first establish an internal team, ensure financial and legal readiness, adjust the composition of the board of directors to meet stock market requirements, seek assistance from external parties like underwriters and lawyers, monitor market conditions before setting the IPO date, prepare documents and financial reports for the SEC, conduct tours to introduce the company to potential investors, and ultimately launch the IPO while committing to fulfilling promises made to investors.
What are these promises exactly?
Broadly speaking, the promise revolves around enhancing investor prosperity. This entails maintaining financial performance, including profitability and cash levels, to either pay dividends or have funds for continued investment with retained earnings, thereby ensuring the stock price continues to rise.
Another aspect involves the proper utilization of IPO funds. If the promise entails issuing shares to settle debts, then those debts should indeed be paid off. Conversely, if the funds are earmarked for investment (CAPEX), they should be utilized for that purpose and not for debt repayment.
Common Shareholder Rights: Essential IPO Knowledge
It's important to understand the rights associated with buying shares in a company.
Investors who acquire common shares of a company possess rights that other investors, such as bondholders or preferred stockholders, do not have.
What are these rights exactly? Common shareholders enjoy voting rights and preemptive rights.
Voting rights empower them to participate in shareholder meetings, which includes decisions on director elections and approval of significant changes.
Preemptive rights enable shareholders to maintain their ownership stake by purchasing new shares in proportion to their current ownership when a rights issue arises.
Armed with these two rights, shareholders can actively manage and fortify their position in the stock market, rather than merely waiting passively for dividends and capital gains.
Common shareholders can comprise individuals, institutions, or corporations.
IPO Share Price Valuation: Methods Demystified
Another aspect to consider before purchasing IPO shares is determining the fair share price.
According to chittorgarh [2], there are at least two ways to calculate IPO share valuation: the Relative Valuation Method and the Absolute Valuation Method.
Unlocking IPO Value: The Relative Valuation Approach
In this approach, analysts compare key ratios of similar companies that have gone public to gauge the value desired by investors.
The steps involved are as follows:
- Identify similar companies in the same industry.
- Determine various valuation ratios for comparison, such as the price-to-earnings (PE) ratio, enterprise value, earnings per share, among others.
- Compare these values across all similar companies.
- Determine the value of the company going public after adjusting for certain factors such as strength, risk, and growth potential.
For instance, if you're assessing the valuation of a telecommunications company using the relative valuation method with a price-to-earnings (PE) ratio:
Firstly, locate companies in the telecommunications sector that have gone public and share characteristics similar to the company in question.
Next, compile price-to-earnings (PE) ratio data from these similar companies. For example, if you find that the average PE ratio of similar companies is 20.
Upon obtaining industry PE ratio data, compare the company's PE ratio with the average PE ratio of similar companies.
For example, if the company's earnings before interest and taxes (EBIT) amount to $20 million, then:
| Description | Value |
|---|---|
| The fair value of the company | Industry PE * EBIT |
| = 20 * $20 million | |
| = $400 million |
Subsequently, after obtaining this value, it's necessary to adjust it for factors like strength, risk, and growth potential. For instance, if the company is relatively new, you might adjust for a lower PE ratio, perhaps in the range of 15-20%.
If opting for a 15% PE ratio, then:
| Description | Value |
|---|---|
| The fair value of the company | Adjusted industry PE * EBIT |
| = 15 * $20 million | |
| = $300 million |
Thus, based on relative valuation using the PE ratio, the value of the company ranges from $300 million to $400 million, contingent on the adjusted factors.
Assessing IPO Value: The Absolute Valuation Approach
In this method, the current value of the company is determined based on projections of future cash flows. The steps are as follows:
- Make cash flow projections for a certain period.
- Calculate the weighted average cost of capital (WACC) as the discount rate.
- Calculate the present value of the projected cash flows.
- Add the terminal value (value at the end of the projection period).
Allow me to simplify with an example!
Suppose we want to evaluate the company's value for the next 5 years. Here are the projected cash flows for each year:
| Year | Cash Flow |
|---|---|
| Year 1 | $5 million |
| Year 2 | $6 million |
| Year 3 | $7 million |
| Year 4 | $8 million |
| Year 5 | $9 million |
Next, we will calculate the company's cost of capital utilizing the weighted average cost of capital (WACC) method. For the sake of simplicity, let's assume the cost of capital is 10%. By the way, you can utilize our WACC calculator, which is designed to compute both the cost of capital and WACC.
Now, let's calculate the present value of future cash flows over the next 5 years at the WACC discount rate, as follows:
| Year | Calculation | Present Value |
|---|---|---|
| Year 1 | $5 million / (1+0.1)^1 | $4.55 million |
| Year 2 | $6 million / (1+0.1)^2 | $4.96 million |
| Year 3 | $7 million / (1+0.1)^3 | $5.26 million |
| Year 4 | $8 million / (1+0.1)^4 | $5.48 million |
| Year 5 | $9 million / (1+0.1)^5 | $5.59 million |
Next, let's calculate the terminal value using the provided formula:
| Description | Value |
|---|---|
| Formula | Terminal Value = (Cash Flow Year 5 ×(1+Growth Rate)) / (WACC - Growth Rate) |
| Given: | |
| Cash Flow Year 5 | $9 million |
| Growth Rate (G) | Assumed 3% or 0.03 |
| WACC | 10% or 0.10 |
| Terminal Value | ($9 million × (1+0.03)) / (0.10 - 0.03) = $132.43 million |
The final step is to sum all the present values of the projected cash flows and the present terminal value to get the current value of the company:
| Description | Value |
|---|---|
| Company Value | $4.55 million + $4.96 million + $5.26 million + $5.48 million + $5.59 million + $132.43 million |
| Company Value | ≈ $158.27 million |
Demystifying IPO Share Accounting: What Investors Need to Know
Don't assume that just because you're not involved in a company's financial management activities, you don't need to understand the accounting for IPO share issuance.
This knowledge is crucial so that you're not left clueless about the impact of IPOs on a company's capital structure as reflected on the balance sheet.
Later on, when you purchase shares during an IPO, they will be recorded on the company's balance sheet under equity, as illustrated below:
| Owner's Equity Balance | |
|---|---|
| Common Stock-xxx par value, xxx shares outstanding | xxx |
| Additional Paid-in Capital | xxx |
| Total Contributed Capital | xxx |
| Retained Earnings | xxx |
| Total Owner's Equity | xxx |
Feeling confused? This represents the money you paid, which will be recorded by the company under common stock.
But what exactly is Additional Paid-in Capital?
Additional Paid-in Capital arises when shares are purchased above their nominal value.
Here's the gist: when a company issues its shares, various scenarios can unfold. Some prices may be above the par value of the shares, while others may align with it.
As defined by Investopedia [3], par value, also known as nominal or original value, is the value of a stock certificate, as stated in the corporate charter. Stock certificates issued for purchased shares display the par value.
Now that you're familiar with these concepts, allow me to delve into the accounting or recording practices undertaken by the company when issuing shares. This applies to both IPOs and rights issues.
IPO Share Issuance: Accounting at Par Value
When shares are sold at their nominal value, the company debits cash for the total amount received from the sale of shares and credits the common stock account for the total nominal value of shares issued.
For instance, if XYZ Corp issues 10 thousand additional common shares with a nominal value of $10 thousand and receives $100 million in cash, the company records it as follows:
| Account | Debit | Credit |
|---|---|---|
| Cash | $100 million | |
| Common Stock (par value $10 thousand) | $100 million |
On the balance sheet, it would appear like this:
| Owner's Equity Balance | |
|---|---|
| Common Stock (par value $10 thousand, 30,000 shares outstanding) | $300 million |
| Additional Paid-in Capital | $0 |
| Total Contributed Capital | $300 million |
| Retained Earnings | $100 million |
| Total Owner's Equity | $400 million |
Prior to the IPO, XYZ Corp had 20 thousand common shares outstanding. After the IPO, the number of outstanding shares increases to 30 thousand.
The additional paid-in capital is zero because the shares were sold at the same price as the par value.
Retained earnings reflect the accumulated earnings earned by the company before the IPO. These are the earnings generated and accumulated by the company from operations before the issuance of additional shares.
IPO Share Issuance: Accounting for Premium Value
When the issuance price exceeds the nominal value, the difference is termed additional paid-in capital.
XYZ Corp debits cash for the total amount received from the sale of shares, credits the common stock account for the total nominal value of shares issued, and credits additional paid-in capital with the disparity between the issuance price and the par value of shares.
For instance, if XYZ Corp issues 10 thousand additional common shares with a nominal value of $10 thousand and sells them at a price of $15 thousand per share, the accounting entry would be:
| Account | Debit | Credit |
|---|---|---|
| Cash | $150 million | |
| Common Stock | ($10 thousand × 10 thousand shares) $100 million | |
| Additional Paid-in Capital | $50 million |
Therefore, unlike issuance at nominal value, in issuance above par or at a premium, the balance sheet would appear as follows:
| Owner's Equity Balance | |
|---|---|
| Common Stock (nominal value $10 thousand, 30,000 shares outstanding) | $300 million |
| Additional Paid-in Capital | $50 million |
| Total Contributed Capital | $350 million |
| Retained Earnings | $100 million |
| Total Owner's Equity | $450 million |
Note! The surplus price above nominal value is not recorded by the company as common stock value, but rather as additional paid-in capital or premium on common stock.
What if the purchase price is below par value?
It indicates a discount, thus it would be presented as a contra account to common stock, which is an equity account with a negative value, serving as a counterbalance to common stock.
IPO Investing: Weighing the Pros and Cons
Investing in Initial Public Offerings (IPOs) entails both advantages and disadvantages that require careful consideration.
As noted by Fortune [4], one of the primary advantages is the potential for significant long-term gains. Moreover, investors can contribute to a company's growth through IPOs.
However, the IPO process often lacks transparency, making it challenging for investors to conduct thorough analysis. Additionally, the IPO stock price may not accurately reflect the true value of the company. Finally, there is a notable risk of financial loss if the company fails to meet its promised expectations.
Therefore, conducting thorough research is essential before investing in IPOs.
IPO Investing: Conclusion for Informed Decision Making
Investing in IPO shares presents an opportunity to diversify your portfolio, but it demands careful preparation.
An IPO marks the initial stage for a company to offer its shares to the public, and share price valuation can be conducted using relative and absolute methods.
Through purchasing shares, investors acquire voting rights and the option to purchase new shares, underscoring the importance of understanding the accounting behind share issuance.
Ultimately, while IPOs hold the potential for long-term gains, there are associated risks, such as lack of transparency and uncertainty in stock prices. Thus, thorough research is imperative before engaging in IPO investments.
ARTICLE SOURCES
- How to prepare for an IPO: A comprehensive 10-step guide. https://mnacommunity.com/insights/how-to-prepare-for-an-ipo/. Accessed May 6, 2024.
- IPO Valuation. https://www.chittorgarh.com/book-chapter/ipo-valuation/. Accessed May 6, 2024.
- Par Value of Stocks and Bonds Explained. By James Chen. https://www.investopedia.com/terms/p/parvalue.asp. Accessed May 6, 2024.
- What is an IPO and should you invest in one? By Mia Taylor. https://fortune.com/recommends/investing/what-is-an-ipo/. Accessed May 6, 2024.
