How to do a Realistic Valuation for New IPO

In general, when a new company goes for an Initial Public Offering (IPO) it is doing that in order to generate capital for growing its business of buying assets. The question then becomes how we investors can evaluate fair value of such a stock. Since my blog is focused on do-it-yourself individual investor, I will use that as my frame of reference. That is, how does an individual investor understand the fair value of such a company? In this process I will use Reliance Power’s IPO as an example.

Let us accept this; valuing any company stock is a very subjective process. Each of us will do it a different way and come up with different arguments. This is valid for a new IPO or established company. In case of IPO, we do not have any past data to make an informed decision. So I look at company’s present state, relative comparison the market, and realistic growth potential. Let me explain this using an example of Reliance Power’s IPO.

In January 2008, Reliance Power came out with its initial public offering of Rs. 10 per share face value and 26 crore equity shares. The company priced it at Rs 450 per share (i.e. Rs. 440 per share premium). It is an IPO so premium pricing is justified and to top it off it was a Reliance brand. I asked myself, is this premium justified? With this premium pricing the company intended to raise a total of approximately Rs. 11,563 crore (after IPO expenses).

First, let us see if we can justify the premium pricing. The company’s annual financial report ending March 2007 shows it had a net profit after tax of Rs. 16.10 lacs. Based on the equity base at that point in time, the earrings per share was Rs. 0.01 only. In addition, it was stated in the IPO prospectus that the money is being raised to buy lands and build power stations, meaning to buy assets for the company. There was kind of slip through on how it will use these assets to generate earnings! After buying assets one needs resources to make it operational (fuel, water, transmission, power purchase agreement, etc) I distinctly remember, when somebody asked about company’s plans for coal? The Chairman had said, if they cannot get coal from India, they will buy their own ships to import coal from Australia! Buying own ships!! Anyways…..

So what is the valuation for the company at IPO? [450 per share] divided by [0.01 earning per share], you do the math. This kind of valuation will make Ben Graham turn in his grave. In general, market valuations are anywhere from PE of 20 to 50. Thus, the company will have to generate earnings per share of Rs. 22 to Rs. 9.00. Can it generate that level of earnings? As March 2008, the Reliance Power had EPS of Rs. 0.17.

I looked at NTPC which is India’s biggest power producer. It has a capital base of Rs. 8245 crore (Reliance power had Rs 2259 crore including IPO), and generates earning per share of Rs. 9. This is approximately four times the capital base to generate Rs. 9 per share. How will Reliance Power achieve that level with only Rs. 2259 crore? NTPC is a very well established player with the full supply chain in place. i.e. coal, power, transmission, purchase agreements, easy access operational capital, etc. In addition, during January 2008, the NTPC stock traded in the range of Rs. 188 to Rs. 282.

Now as an individual investor, I would be nuts and delusional to invest in no name no experience company at such a hefty valuation. More so because when I already had NTPC at an attractive price level. I would agree that power sector is green field with long term growth potential and Reliance brand, so what? Paying such a high valuation for a stock with no earnings and no assets isn’t really investing, it’s mostly speculation. I would have invested in Reliance Power had it priced its offering anywhere below Rs. 50. Anything beyond that would not have been not attractive to me.

Summary is….

Investors need to see if there is justification for such high premiums. Compare its investment preposition with industry practice to see if it makes sense. Again this discussion is valid for individual investors like us. If we look from ownership or majority stake standpoint, this would be completely opposite.

So that was about how to understand the justification for high premium. In my next post, I will take this further to explain how this mass hysteria and madness about IPO would have (or perhaps may have) benefitted the company and its owners.

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9 Responses to “How to do a Realistic Valuation for New IPO”

  1. Not-so-Smart says:

    this is an excellent tip TIP GUY. i have been burnt badly in reliance power IPO. I wish i had this kind of analysis before i applied for IPO.

  2. Sherin says:

    In my personal view, I am totally against to the IPO investing and always informed my friends to not go for that. Whatever the price it is, IPO generally have a fully valued price and leave no room for increase. When it listing to the market, real investors start valuing the stock and on the basis of such, the price movement happen and it will reach to the right price. It may be far far down from the original IPO price. RPower is the best example. By seeing the brand name, those who have invested to Rpower stock, suffered huge lose. A simple question here, Rpower has lots of projects in their hand but where is the money to execute? If they go for debt, then how much? Of course, such receiving debt will be double or tripple than their present asset and thus the company will move close to bankruptcy. By considering this, is it best for go for their IPO to get huge lose?

    Investor should have little commen sense to think before doing each action. Or can be a person like those who invested in fully valued stocks that possibly come down to earth than going to sky.

    The Money Maniac

    Sherin’s last blog post..My Dream Eco friendly home features

  3. Hi,

    Nice article. Agree with Sherin that we should stay away from IPO’s. Should invest in companies which have a decent track record.

    Dilip Lillaney

    Dilip Lillaney’s last blog post..Punj Lloyd Ltd.

    • TIP Guy says:


      In a well diversified portfolio, investor do need growth companies. I am not against investing in IPO if it is priced as my per risk appetite. Unfortunately, there is so much hype, the promoters milk it very nicely.

      Best Wishes,

  4. stock says:

    OHH Very Interesting post! Thank you for such interesting resource! PS: Sorry for my bad english, I’v just started to learn this language 😉 See you! ^_^

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