Revisit the valuation methodology of IPOs.

There are two ways to finance a company. One is a capital contribution out of either owner’s or major shareholder’s pocket.  It is quite simple and convenient way to supply its capital for the company not only because there is no need to pay any interest payment unless it is noted, but any complicated borrowing process shall be necessary. However, if either owner or major shareholder may not be able to contribute, the company has no choice but to the other way; borrowings, in order to meet financial needs for the business operation. Since it is borrowing from others, it is followed by certain conditions, such as bilaterally agreed interest payment in regular basis with a specific repayment plan if it is a type of generic bond or offering converting right to creditors who owns convertible bond; which make them convert its borrowings to acquire certain portion of share and become a shareholder without any additional expenses meanwhile their amount of borrowings shall be decreased in proportion to the amount to be converted. Most of either unlisted or listed companies, also known as public companies expect to have certain amount of borrowings in their financial statement. In order to sustain its growth potential and reserve abundant cash flow, the company prefers to use borrowings as long as it is advantageous. For a public company, it is easier to deliver its financing than an unlisted or private one because there are numerous public investors are available to either invest or lend their money for the company as long as it is financially good shape and excellent growth potential since it is publicly listed on the stock market. That is why most of startups and small-mid size companies are anxious to go public and become a listed company eventually.

To proceed to IPO process, any candidate company is necessary to assign an underwriter from securities. Assigned underwriter manages to file all relevant documents and evaluate the value of a company if it is listed at the initial stage. During the valuation process, an underwriter should be able to consider all valuation options to estimate the intrinsic value of a company referring to the size of public demand. Options for valuation of IPO are as follows; PER, PER and EV/EBITDA both, PER and PBR both, PBR and EV/EBITDA both. Evidently underwriters are eager to maximize the initial value of the company because their fee amount depends on it – usually fee payment to be determined by the amount of fund publicly raised. However, unnecessarily overvalued IPO causes adverse effect. According to Korean financial watchdog, Financial Supervisory Service (‘FSS’), it is clear that the price of recent IPOs listed from 2008 to 2009 had dropped below from the original price value soon after a company is listed. Since any radical movement of price could trigger a high volatility of stock market and distort real value of the company; which would bring about severe losses to numerous public investors participated at the initial stage, currently FSS set out to review the valuation process of IPOs. Based on the survey, most underwriters preferred PER method to other various options even though the other methods are strongly recommended during the valuation process.

Among newly entered companies listed from early 2008 to late 2009, 97 of them are estimated by PER method to estimate their IPO price. The average PER multiple of 97 cases (13.1 times) exceeded other cases (10.9 times) by almost 20% higher. Particularly companies used by PER method failed to show average price performance of total listed companies (13.6%) estimated from the first month after listed: merely 5% in average.  Meanwhile, those who were valued less than average PER multiple initially show a better price performance up to 24.6% at the same period. It represents that price performance is in converse proportion to the initial value of companies according to this study.

In addition to the valuation method mentioned above, 59 cases were estimated by income approach, such as DCF(Discounted Cash Flow), which projected future revenue and income over the next five years at least also failed to meet its figure of initial projection scenario. Its discrepancy between projected and actual outcome is more than 22% in average. In spite of the fact that the projection may not be accurate and it should be allowed to understand the difference with actual figure due to the unexpected event or other externalities which affect business operation and financial performance, it reasonably causes a doubt on the initial value of IPOs.

Also massive selling spree by institutional investors contributed to a significant price drop of newly listed companies. FSS reported that at least 50% of newly issued share had been sold by institutional investors within the first 4 weeks right after listed at the stock market. Furthermore, securities and asset management among institutional investors had sold their shares in advance up to 81.7% and 66.0% respectively at the same period.

Whereas IPO is in the middle of overvaluation issue, SPAC, introduced as an alternative way to IPO, seemed to be in trouble due to the overly undervalued issue. According to the press, SPACs are restricted to estimate the value of target companies in terms of valuation practices. In a nutshell, the estimated value of same company can be significantly undervalued under the rule of SPAC in comparison to IPO.

To respond to this abnormal phenomenon on IPO practices, financial officials pledged to set up the certain guideline of IPO process; obliged to provide reasonably acceptable data and analysis on the valuation, led to invite mid and long-term investors rather than short-term seller. It is evident that unreasonably overvalued IPO without any objectivity and consensus could cause quite a distortion in the stock market and give damage to public investors who does not have a enough information compared to early institutional investors and related insiders. Need to try to approach to the real intrinsic value of company at least.

Jin Mok Kim (jinmok.kim@gmail.com)

Abbreviation

IPO : Initial Public Offering

PER : Price Earning Ratio

PBR : Price on Book-value Ratio

EV : Enterprise Value

EBITDA : Earnings Before Interest, Taxes, Depreciation, Amortization

DCF : Discounted Cash Flow

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