Equity pricing in IPO: Exploring deeper insights

Financial literature and theories have undoubtedly made substantial progress about pricing of the financial assets notably common stocks, but unfortunately perhaps these have failed to come up with a uniform, robust approach to what should be the fair worth of an equity stock. One of the most debatable issues in the capital market of Bangladesh in the recent times is that over-pricing of IPOs (initial public offerings) and flawed rules and persons (institutions) are responsible for this. But what is about fair pricing? Book-building method has been suspended for the time being and perspective new issues seem to be not much interested in coming with IPOs. One key reason, among others, relates here to lack of consensus of fair equity price discovery. Let us have a close look at what alternatives we have in IPO pricing. Section 16 of Public Issue Rule (2006) provides the relevant reference for the determination of the offering price of an IPO when an issue is priced above par (above face value, or at a premium). This states that premium should be justified at net asset value (NAV) per share at historical or current cost. As already established companies (in virtual) are only allowed to get the green signal for listing, so historical cost, in effect, makes no sense; rather, liquidation value, net realizable value or fair value (value at which assets can be exchanged between two knowledgeable persons at arm's length transition) per share along with market value, should be allowed to set the basis of price. Then the Public Issue Rule (section 16-b II) states that premium should be decided in the light of earning-based value per share calculated on the basis of weighted average of net profit after tax for immediately preceding five years or for such a short period during which the issuer-company was in commercial operation. In this context, an intending company is usually found to misuse this regulation by issuing a hefty amount of bonus share, just before filing the IPO application, because the weighted average of net profit after tax without any reference to number of outstanding share is another area of loopholes. Moreover, historical net profit after tax-based earning per share (EPS) makes no special separation for discontinued operations or extraordinary items such as disposal of assets, or sale of shares, sale of parts of businesses which has boosted the profit in the recent past but is not expected to continue in the future. Next, the regulation (section 16-b I ) makes reference to average market price per share of similar stocks for the last immediate one year. Perhaps this section is mostly misused. Two stocks are said to be similar when they belong to the same industry, similar in size, product line, revenue size and life-cycle stage as well as alike in capital structure (level of use of debt) and importantly generate a significant percentage of their operating earnings from the same business. Ironically, in our market, it is being witnessed that such considerations are grossly violated because the number of stocks in the capital market is small and many companies do not have any comparables at all (e.g. telecommunications industry) and the industry does not rightly represent itself (e.g. textile industry alone encompasses textile, weaving, dyeing, spinning companies). And importantly a one-year period is not enough to properly track the earnings cycle and stock-market cycle. Because, during the bullish trend, all stocks tend to trade at higher prices and the opposite happens during the bearish period. Unfortunately this cycle does not limit itself to a one-year period. So this period should be extended to properly track the earnings cycle and stock-market cycle, along with a clarity of similar stocks criteria. Recently, the Securities and Exchange Commission (SEC) has removed use of projected earnings (relevant to section 16-b -III of Public Issue Rule). This should, of course, be reintroduced because all the other available methods in financial literature either assume the past business experiences to continue in the future (price based on historical earnings) or relative valuation (price of similar stocks). Essentially, the intrinsic value (also called fundamental value, fair value, true value in finance literature) of a stock depends on its ability to generate cash flow in future (at this point, we feel necessary to note that the past does not always mimic in the future). And this can be derived by forecasting the cash flow (free cash flowoperating cash flowdividend per share), to be generated in the future and discounting the same with an appropriate risk-adjusted discount raterequired rate of return which is usually the cost of equity derived from capital asset pricing model, adjusted for systematic risk or the weighted average cost of capital. Of course, financial analysts have the right to ask who will assure that this forecast performance can be materialized in the future; our simple answer with due respect to them is; who over the past and perhaps in the future has guaranteed that the past performance which has taken into consideration, will to continue in future. Recently, the SEC has stated that it is going to amend the book-building method where provisions have been kept -- if we are not mistaken - for a maximum price for an IPO issue that will be 15 times of priceearning (PE) ratio or five times of net asset value (NAV) per share whichever is lower. If permitted, this is going to be another loophole. Because a stock with 15 PE ratio may be overvalued or even undervalued. For illustration, using the Gordon Growth Model (a very popular model worldwide for determining the intrinsic value of common stock), it is accepted that the fair price (P0) = D1( k-g) or PE1 = (D1E1)(k-g) (D1 is expected dividend; E1 is expected earnings per share, k is the cost of equity required return by investors and g is the perpetual growth rate of the company). The Gordon Growth equation clearly suggests that for given earnings, the higher the growth and lower the cost of equity, the higher should be the price or alternatively, given the earnings, the lower the growth rate and higher the cost of equity, the lower should be the price. What the Gordon Growth Model says is that for the same earnings - EPS, two stocks may have different fair value. But this is missing in our historical earnings-based value per share. Moreover, for certain industry stocks, multiple of price to sales, price to book value, price to operating cash flow, enterprise value (most useful when companies differ significantly in capital structure) of similar stocks can used in relative valuation. Furthermore the issue manager and the issuer must be held responsible, in one way or other, for the determination of price and price support, requiring particularly the issue manger to provide bid-ask price (market making) up to a certain period (six months or one year) with a floor price equivalent to an IPO offering price. A common way in a country like Bangladesh to inflate the stock price is allowing private placements to the influential investors who, in return, tend to keep prices high, until the time it takes for retail investors to be convinced that the stock prices will remain high. Unfortunately for the general investors, the prices never remain at that level. Finally, we would like to conclude here, repeating the quote of one of our favuorite finance teachers -- Professor Salahudinn Ahmed Khan, Dhaka University -- that "the private placement should actually be banned in a country like Bangladesh where a company IPO is oversubscribed by even more than 50 times". The writer can be reached at e-mail: sajibfin06@yahoo.com