Valuing IPOs

*Valuing IPOs

Moonchul Kim ,Jay R. RitterPresenter

*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.

*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.


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 ) .


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.


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

* 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.

1. Introduction (Cont.)

*There is a presumption that many IPO firms have valuable 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.

1. Introduction (Cont.)

*Valuation Methods :

(1) Comparable firms approach . (2) Discounted cash flow approach (DCF) . (3) Asset-based approach .2.Related literature -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.

2.1 Alternative valuation frameworks

* The estimated market price of the IPO firm= EPS of the IPO firm the average or median P/E ratios of comparable firms

2.1 Alternative valuation frameworks( Cont. )

*The comparable firms approach works bestwhen 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 sectorBeing undervalued or overvalued.2.1 Alternative valuation frameworks( Cont. )

*

Boatsman and Baskin (1981) compare theaccuracy of two different samples of P/E models.

Absolute prediction error = log (predicted price) log (actual price)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.


* 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.


* 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.


* 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.


*Asset-based approach :It looks at the underlying value of a companys assetsto indicate the companys value. It is more relevantwhen a significant portion of the assets can beliquidated at a well-determined market price.

Disadvantage:In most IPOs , the asset-based approach isinappropriate because most of their value comesfrom the future growth opportunities.


*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. 2.2 Valuation studies in a non-market setting

*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.

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.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.


*

Gilson et al.(1998) find that , for firms emerging from bankruptcy , DCF method has the same accuracy as the comparable firms approach.


*3. DataThis paper uses a sample of 190 domesticoperating company IPOs from 1992 to 1993.

Why it restricts sample to 1992 to 1993 IPOs??

*3. Data(Cont.)

Sample selection criteria:NUniverse of firm commitment, nonunit, nonfinancial domestic operating company IPOs832Exclusion of reverse LBOs and total divestiture of subsidiaries164Remaining668Exclusion of IPOs with proceeds < $ 5 million or offer price < $ 5.0056

*3. Data(Cont.)

Remaining612Exclusion of firms with EPS 0 in the 12 months prior to the offer194Remaining418Exclusion of firms with preissue book value 048Remaining370

*3. Data(Cont.)

Exclusion of IPOs when there is no IPO in the same (four-digit) industry in prior 12 months180The sample were used in this paper190

*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.

*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.

*3. Data(Cont.)

*4.1 The Comparable firms approachMany market multiples can be used in thecomparable firms approach, includingindustry-specific ratios.

Amir and Lev (1996) provide a valuationstudy of wireless communication industry.

*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 significantrelationship between E/P ratios and growth, dividend payout, and size.

*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.

*4.1 The Comparable firms approach(Cont.)This paper uses two groups of firms forthe comparables: 1. recent IPOs 2. firms chosen by a research boutique

*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??

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

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

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

*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.

*4.1 The Comparable firms approach(Cont.) Figure 1 illustrates the logic of using comparable firm multiples and the reality.

*4.1 The Comparable firms approach(Cont.)

*4.2 Recent IPOs as comparable firmsComparable 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.

*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?

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.

4.2 Recent IPOs as comparable firms

*P/E: Price/Pre-IPO EarningsM/B: Market value/ Postissue book valuesP/S: Price/ SalesPrice:IPO firm--offer price Comparable firms--market price on the day before issuing 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) < 0.154.2 Recent IPOs as comparable firms

*4.3.OLS RegressionDependent variables: IPO firms multipleExplanatory variables: comparable firms multiplesThe null hypothesis: a1 = 1

*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 coefficiente = the standard deviation of the measurement errorx = the standard deviation of the true explanatory variable4.3.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. 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.

4.3.OLS Regression

*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

*Preliminary offer price range (POP)Final offer price (OP)First market price (Pmarket)Additional information: market demandComparable firms market multiplesFirst day closing price4.4 The relative importance of multiples at different stage of the offering

*P/Ei = a0 +a1 P/Ecomp,i + eiThe following relation is expected to hold: AVEPOP < AVEOP < AVEmarket where AVE = log (predicted multiple) - log (actual multiple) = the average absolute valuation error4.4 The relative importance of multiples at different stage of the offering

*4.4 The relative importance of multiples at different stage of the offering

*5. Valuation using earnings forecasts and comparables from Renaissance Capital Picking comparable firms with Renaissance Capital research reports, not with the same SIC codes.

*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.

*How to calculate P/E ratios ?For IPO firms: P: offer price E: last 12 months current fiscal years forecast next years forecast

*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

*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.

*The data informationSize: 143 IPOsSample period: September 1992 to December 1993IPOs evaluations are available from RC, and comparable firm multiples are available from CompuatatDow Jones: < 4000

*5.2. Valuations using forecasted earnings, and for young and old firmsExplanatory variable: geometric mean of the RC comparables firm P/E multiplesDependent variable: three P/E ratios of IPOs

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

*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.

*Some information of the Table 6RC 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.

*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.

*Why the slope coefficients are below 1 and the R2s are below 100%?difference growth ratesThe standard growing perpetuity valuation model:

*Rapidly growing firms going public may be view by the market as having transitory component in their earings.

*Why doesnt Renaissance Capital choose M/B ratio?

Other multiples: price-to-sales enterprise value to operating cash flow enterprise value to sales

5.3 Valuations using multiples that invariant to leverage

*5.3 Valuations using multiplesthat invariant to leverage(Cont.)Table7:(please turn to page 432) In Panel A: price-to-sales ratio

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

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

*=1,if the sales of the IPO are growing faster than the midpoint of the comparable firms growth rate.=0, otherwise Dummy variable5.3 Valuations using multiplesthat 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. 5.3 Valuations using multiplesthat 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. 5.3 Valuations using multiplesthat 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.5.3 Valuations using multiplesthat invariant to leverage(Cont.)

*Definition:

VII. Comparable multiple is computed as the geometric mean of the multiples for the two comparable firm.

5.3 Valuations using multiplesthat invariant to leverage(Cont.)

*Absolute Prediction errors P/S:(1) 56

EV/Sales:(5) 52.8

EV/OCF:(9) 43.2 Mean(%) Table 7Absolute Prediction errors(1)12-month historical 55

(1)12-month historical 55

(2)Current year forecast 43.7 Mean(%) Table 65.3 Valuations using multiplesthat invariant to leverage(Cont.)

*Table8: =1,if the percentage increase in sales in the prior year of the IPO is > the midpoint of the percentage increase in sales for each of the two comparable firms.=0, otherwise PROFIT-ABILITY5.3 Valuations using multiplesthat invariant to leverage(Cont.)

*Absolute Prediction errors Mean(%) Table 7Absolute Prediction errors(1) 50.3

(2) 48.8

48.5

(4) 38.2 Mean(%) Table 8Panel B:(5) 52.8

(6) 52.1

(7) 50.4

(8) 51.6 5.3 Valuations using multiplesthat invariant to leverage(Cont.)

*Parameter estimates

(2) 0.218 0.199 (4.18) (2.90)Profitability multipleTable 8multiple5.3 Valuations using multiplesthat invariant to leverage(Cont.)

*6. ConclusionsFirst, 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.

*Secondly, boutique works better than recent IPO. Absolute Prediction errorsP/E 5.0 56.5 Mean(%) Table 4:recent IPOAbsolute Prediction errors Mean(%) Table 6:boutique(1) 8.3 52.86. Conclusions(Cont.)

*Thirdly, the authors also find out The valuation accuracy is higher for older firms than young firms.

6. Conclusions(Cont.)Absolute Prediction errors Mean(%) Table 6Young 31.9Old 23Absolute Prediction errors Mean(%) Table 7Young 48.2Old 28.2Absolute Prediction errors Mean(%) Table 8Young 48.5Old 38.2

*Finally, additional adjustments can more improve the valuation accuracy.

And the magnitude of adjustments is consistent with the industry practice.

6. Conclusions(Cont.)

*THE END

***Later, well see two terms in Table 3, Panel B. They are prediction errors and the percentage of predicted valuations within 15% of the actual multiple. How to calculate the prediction errors? They use the natural log of median comparables multiple minus the natural log of IPO multiples. Here the multiple means those ratios we mentioned above --- the P/E ratio, the M/B ratio, and the price to sales ratio. For the percentage of predicted valuations within 15% of the actual multiple, the predicted value actually comes from the simple multiple approach which mentioned. They set the intercept becomes zero and the slope coefficient becomes one. The explanatory variable is the median of comparable firms multiples. So if the median of comparable firms P/E is 3, then the predicted multiple of the IPO firm is 3. But the predicted multiple is different from the actual multiple we observed, so this term actually means the absolute value of the prediction error. So the percentage of predicted valuations within 15% of the actual multiple means how many percentage of the sample will have prediction error within 15%. Of course, if the percentage number becomes larger, it means the prediction error is smaller, and the prediction have higher accuracy.*Here is Table 3, Panel B. Those numbers are the distribution of the prediction errors. For the prediction errors, the mean and median values are all positive. This is consistent with the IPO underpricing phenomenon. For the percentage of predicted valuations within 15%, the author use two different definitions of the price for the actual multiple. First is OP, the offer price. The second one is Pmarket, the first closing market price. As you can see, the percentage is not very high.At most, they are 21%.That means the prediction have low accuracy.Also notice that when we use the offer price in the actual multiple, the percentage is higher than the first closing market price, although their differences are not significant. That means when we use the comparable firm approach do some predictions, the predicted multiple somehow will be closer to the actual multiple when the actual multiple is defined in the offer price. This implies that the offer price and the first closing price have different importance in the stage of the offering. We will explain again later. *Now we run the OLS regression. There are three equations. The dependent variable is the IPO firms multiple, and the explanatory variables are the comparable firms multiples. And the null hypothesis says, if the comparable firms approach work well, if we can use the comparable firms multiples predict accurately the IPO firms multiple, the slope coefficient a1 should become 1. In other words, IPOs with high comparable firms multiples should have their earnings, book value, or sales being estimated at a higher rate.*So if we use the comparable firms multiple do the predict, we should expect that the average absolute valuation when predicting first day closing price will be the largest, then is the final offer price, then is the preliminary offer price.

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Valuing IPOs