How to Price an IPO Before It’s on the Market

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There’s few things more exciting for an investor than being one of the first to own shares of a newly issued stock. Oftentimes these stocks can climb quickly, resulting in gains of 10%, 20%, 50% or more in a short amount of time – in a matter of weeks or even days. But they can also turn the other way and never again find themselves at the same value of their original issue price.

While finding a fair value for a stock that’s been trading for years is relatively easy to pinpoint, trying to analyze a stock with no trading history is more difficult. There’s no regression analysis that can be done and no historical earnings record to pour over. However, that doesn’t mean a fair valuation can’t be found – one just needs to know how to apply the metrics.

Finding a fair value for a new stock

An IPO (initial public offering) is what happens when a company sells shares of stock and becomes publicly traded. The company will then use that capital to invest in capital infrastructure or investment in order to grow the company.

But pricing an IPO requires a bit of thought in order to get an accurate number. It might seem arbitrary, but there’s some reasoning behind these prices. Getting an exact figure isn’t realistic, but one can at least understand how prices are derived.

Like all economics, supply and demand plays a role in pricing. In this case, it’s the market demand for certain industries. If tech is popular and a tech company goes public, it may be priced higher than a mining company going public.

Of course one of the best ways to get a good idea of value is to look at comparable companies. Comparing the new issue to its closest competitors will give you an idea of how much the stock should be trading for. If the industry average price-to-earnings ratio is 15, then you know that the new stock should have a price-to-earnings of around that figure.

Another important consideration is the company’s growth prospects. If growth is projected to be high, the IPO should reflect that growth, and vice versa. This can be hard to gauge, so a brief look at the industry’s current health and the company’s plan for growth is a must for due diligence.

Finally, investors need to be honest about the marketability of the stock itself. A company with a new product or ground-breaking business model will add value to the stock, whereas a company that’s just trying to accumulate more capital will attract less attention.

Final thoughts

IPO’s are highly risky investments due to the uncertainty surrounding valuation. Investors should note that IPO’s are generally issued when market demand is high, not when demand is weak. This means IPO’s will naturally get a boost from current demand, which may not reflect their fundamental value. Caution should be exercised when considering adding an IPO to your investment portfolio.