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Paper Abstract: Examines valuation tools (techniques) and the decision-making process. The two phases of the valuation process: pricing & market evaluations. Market's response to company's initial public offering (IPO). Pricing of an IPO. Background information on IPOs. Various decision-making models; Capital Asset Pricing Model (CAPM). Effects of institutional investors. Paper Introduction: VALUATION OF NEW PRIVATE COMPANIES Introduction The valuation of new private companies is examined. Valuation tools (techniques) and decision-making processes are addressed in the examination. The valuation process for new private companies occurs in two phases. The first phase is the pricing evaluation. The objective of this phase is to determine the initial offering price for shares in the new company. The second phase is the market evaluation. The results of this phase reflect the actual worth of the new company based on the market’s response to the company’s initial public offering (IPO). IPOs are equity stock issues when a corporation first initiates public trading of its shares. Text of the Paper: The entire text of the paper is shown below. However, the text is somewhat scrambled. We want to give you as much information as we possibly can about our papers and essays, but we cannot give them away for free. In the text below you will find that while disordered, many of the phrases are essentially intact. From this text you will be able to get a solid sense of the writing style, the concepts addressed, and the sources used in the research paper. (1996, December). 144). Issuing corporations, thus, should not pursue an "objective of getting themaximum price" for an IPO (Smith, 1994, p. American IPOs: What crash? F. New York: McGraw-Hill Inc. They are right tobe worried .... Itis unlikely that such timely comparable peers exist" (Zent, 199 , p. Zent, C. 5 ). Although it is, at once, obvious that several of the basic assumptionshave little or no relevance to the actual conditions which are encounteredby investors, the assumptions do permit the derivation of relationshipsbetween specific securities and the market as a whole (Brigham, 2 ).Thus, the derived risk premium will likely be valid, although the modelwould not likely be successful in the derivation of a base price for thesecurity (which, it must be added, is not the purpose of the CAPM). The basic model is referred to as the Sharpe-Lintner-Mossin capitalasset pricing model, and employs the variance in expected return of aninvestment as the measure of risk. 3. All investors are price takers (that is, all investorsassume their own buying and selling will not affect stock prices). Wanted: The right investmentbanker. 285).The average reported initial return on the first day of trading on IPOsfloated during the 196 -1987 period, as an example, was 16.4 percent(Ibbotson, Sindelar, & Ritter, 1988). Principles of corporate finance. Brealey, R., & Myers, S. The effect of the secondarymarket on the pricing of initial public offerings: Theory and evidence.Journal of Financial and Quantitative Analysis, 27, 55-8 . (1989). This assumption,too, is one which is often difficult to fulfill in real world situations. The IPO of Starbucks Coffee in 1994 provides anillustration of the role of institutional investors in the success of IPOs. (1984). Analyze the market pricing mechanism for each comparablepublic firm. Englewood Cliffs, NewJersey: Prentice-Hall, Inc. (1992). Bivarate spectral analysisof the capital asset pricing model. capital-asset pricing model, all securities andportfolios plot on a security market line going through a pointrepresenting the riskless rate of interest" (Sharpe, 1999, p. 164). 18). Journal of Finance, 44, 393-42 . Sharpe, W. Thesesteps are as follows (Bielinski 64): 1. Over time,however, IPOs generally tend to under perform in relation to the market asa whole. Many of theentities making pricing recommendations have interests in the IPO which maycause their pricing recommendations to be biased. 7. (1993, March). The second is the riskof litigation due to legal liability (Tinic, 1988; Hughes & Thakor, 1992).The third is the monopsony power of investment banks (Ritter, 1984). These differences make ... B. Grinblatt, M., & Hwang, C-Y. While theCAPM is relatively simple and straight-forward as a descriptor of therisk/return relationship, it is evident that, in practice, some thornyproblems will likely be encountered. To state that an IPO pricewas either too high or too low, therefore, is largely a matter of judgment. Journal of Applied Corporate Finance, 1, 37-45 Krongard, A. In 1 or 2 years' time we will probably have much bettertheories .... Set a price for the issuing corporation IPO based on thefindings of 2 and 3 above. Hughes, P. 143). The difficulty with this approach is finding trulycomparable peer multiples. Traditional approaches to setting andassessing IPO pricing "rely on applying key multiples (price/earnings,price/sales, market/book, etc.) of 'comparable' publicly traded peers tothe IPO candidate. 65). Pappas, J. Institutional investors in the United States were allocated a 45 percentshare of the Starbucks IPO. 65)? (1999). "Under theassumptions of the ... Maurer, D. Identify publicly traded companies similar to the issuingcorporation. The beta coefficient of a security is used to determine the level ofthe market risk premium of a specific security-how much additional returnmust an investor anticipate receiving from a risky security, in order tojustify holding that risky security in lieu of a riskless asset, which inthe United States generally is presumed to be United States Treasuryinstruments (Brealey & Myers, 1999). (1999). (199 , October). All investors can borrow or lend an unlimited amount at agiven risk-free rate of interest, and there are no restrictions on shortsales of any asset. W. Anatomy of initial public offerings of common stock.Journal of Finance, 43, 789-822. Chemmanur (1993) argued further that the under pricing of IPOs ismotivated "by the desire of firm insiders to induce information productionabout their firm" (p. Goldberg and Vora (1978) traced thedevelopment of the quantitative CAPM to the introduction of his portfoliotheory by Markowitz in 1952. The objective of this phase isto determine the initial offering price for shares in the new company. Signaling by underpricing in theIPO market. (199 , February). Journal ofBusiness, 57, 215-24 . eachinvestment should lie on the sloping market line connecting Treasury billsand the market portfolio" (Brealey & Myers, 1999, p. If such is not the case, theinvestment banker may not provide the best pricing and distribution advicefor the IPO. Brealey and Myers (1999) said thatan advantage of the CAPM is the fact that it provides a "manageable way ofthinking about the required return on a risky investment" (p. (1994, November-December). (6th ed.). (2 ). Investment banking, reputation,and the underpricing of initial public offerings. Issuing corporations are motivated tounder price and IPO because under pricing typically has been found toproduce "greater combined proceeds from the initial and second offerings"(Chemmanur, 1993, p. (1997, November 15). Journal of FinancialEconomics, 15, 187-212. This approach toIPO pricing also leads to increased demand for the equity shares offered.The increased demand, in turn, strengthens the post-offering price of theshares. SVA is based on the "fact that the value of any asset, whether it is amortgage or equity in an IPO, depends on the magnitude, timing and degreeof uncertainty of its future cash flows. One of the principal disadvantages of the use of the CAPM is that itis based on ex ante (expected conditions), while the only actual dataavailable is ex post, or past data (Pappas & Brigham, 1999). The market portfolio is a combination of all securitiesactive in a market. 732). Journal of Finance, 44, 421-449. Research has documented that IPOs which are the most over-subscribedtend to be those characterized by the highest level of under pricing(Beatty & Ritter, 1986). SVA calculates the value of acompany by discounting its expected future cash flows using a rate thatreflects the company's (and therefore the investor's) risk" (Zent, 199 , p.32). Ibbotson, R., Sindelar, J. C., & Senbet, L. The security market line develops the model withrespect to specific individual securities (Brigham, 2 ). J., & Thakor, A. Hinsdale,Illinois: The Dryden Press. The slope of the capital marketline "can be regarded as the reward per unit of risk borne, (and) equalsthe difference between the expected return of the market portfolio and thatof the risk-free security divided by the difference in their risks"(Sharpe, 1999, p. Smith, O. As is often true of the assumptionsincorporated in the securities analysis models, this one is not relevant tothe so-called real world. Valuation Tools and Decision-Making Processes Several factors are considered in both the setting of an IPO price andin the evaluation of an IPO price. The degree of IPO under pricing is larger forthose issuing corporations whose offers are more costly to evaluate(Muscarella & Vetsuypens, 1989). Corporate CashflowMagazine, 11, 64-66. The Effects of Institutional Investors on IPOs Institutional investors have been critical to the success of an IPO.Issuing corporations and investment bankers underwriting and distributingan issue depend heavily on institutional investors to fully subscribe anIPO (Smith, 1994). The essential elements in the functioning of the CAPM are the marketportfolio, the capital market line, the security market line, and the betacoefficient. The investment bank selected to underwrite and distribute an IPO iscritical to the success of an IPO. Investments. Therefore, every security with a beta of .5 "should be priced togive an expected return of the market - .5," and every security with a betaof 1.5 "should be priced to give an expected return of the market + .5"(Sharpe, 1999, p. This determination is made through the use of thecapital market line concept. The equilibriuminitial offer price, which may involve underpricing under certainconditions, emerges from this tradeoff" (p. In thewake of the seven-percent drop in the Dow-Jones Industrials Index thatoccurred in October 1997, small investors, seeking quick returns as thebull market appeared to be imperiled, began turning to IPOs in greaternumbers ("American IPOs: What Crash?" 1997). Chemmanur, T. Brigham (2 )defined the basic assumptions of the CAPM as follows: 1. First, which market multiples are usedby the comparable firms for pricing? Litigation risk,intermediation, and the under-pricing of initial public offerings. P., & Ritter, J. Fundamentals of managerialeconomics. While, as stated above, it is notuncommon for the market value of an IPO to double during the first day oftrading, that pattern is not a given. (1986). This pricing levels"allows for immediate appreciation and encourages buyers to purchase theclimbing stock" (Raymond James Financial, 2 , p. valuation of new private companies Introduction The valuation of new private companies is examined. (1999). Such a strategy is not risk-free. 32). "Preferred investment strategies plot along(a, sic) line ... (1986). Difficultiesare also encountered in the precise formulations of the risk premiums. F. (2 ). Welch, I. All investors are single-period, expected utility ofterminal wealth maximizers who choose among alternative portfolios on thebasis of means and standard deviations of portfolio returns. Thisassumption means that all investors have homogeneous expectations. Reviewof Financial Studies, 5, 7 9-742. (1988). A simple test of IPOunderpricing. Theyadded, however, that many people "are worried by some of the rather strongassumptions behind the capital asset pricing model .... A., & Vora, A. F. The models are based on severaldifferent factors. Chemmanur (1993) argued that the under pricing of IPOs is "one of themost extensively documented anomalies in financial economics" (p. The beta value for the risk-free security is . L., & Ritter, J. Do "thecurrent specific multiples and general market multiples fall near the highor low end of their historical ranges, and do they continue or reverse atrend" (Bielinski, 199 , p. W. V. The market price for average IPOsincrease in the range of 15-to-2 percent over the initial two weeks oftrading activity and many lose value over that period (Raymond JamesFinancial, 2 ). Thesecond phase is the market evaluation. Brigham, E. Among these factors are the following:(1) the past performance of the issuing corporation, (2) current financialand marketing positions of the issuing corporation as of the date of theIPO, (3) the future outlook of the issuing corporation, (4) trends andconditions in the equity market at the time of the IPO issue, (5) theexperiences of comparable corporation in the same industry as the issuingcorporation, and (6) demand for stock in the issuing corporation (RaymondJames Financial, 2 ). A traditional model applied to the pricing of an IPO is the comparable-firm approach. The object of the pricing of an IPO is to obtain a fair price for theissue. Retail investors in the United States wereallocated a 35 percent share of the IPO, while international investors wereallocate a 15 percent share, and Starbucks employees were allocated a five-percent share (Smith, 1994). centenary.edu/~whamon/price.html Ritter, J. 83). 4. Bielinski, D. This relationship is known asbeta. Raymond James Financial. 2. Conclusion The primary criteria for the success of an IPO are that the issue (1)provides the capital being sought by the issuing corporation, (2) ensuresthe liquidity of the issuing corporation, (3) generates a public awarenessof the issuing corporation, and (4) enhances shareholder value. , and "every security with a beta value of 1. The beta value for themarket portfolio is 1. W. R. Journal of Finance,48, 285-3 4. The quantities of all assets are given. Journal of Financial Economics, 15, 3-29. All assets are perfectly divisible and perfectly liquid(that is, marketable at the going price), and there are no transactionscosts. Seasoned offerings, imitation costs, and theunderpricing of initial public offerings. Why new issues are underpriced. Valuation tools(techniques) and decision-making processes are addressed in theexamination. Since both risk and returnare subjective estimates dealing with the future, there is ample room fordisagreement .... , and "every securitywith a beta value of zero should provide an expected return equal to theriskless rate of interest" (Sharpe, 1999, p. 3. Going public: Perilous orprosperous? The comparable-company approach:Measuring the true value of privately held firms. Journal of FinancialEconomics, 15, 3-29. Tinic, S. Second, are any unique expectations orcircumstances reflected in how the market prices each comparable firm?Factors such as "aggressive growth expectations, depression due to recentpoor performance or a host of special circumstances (takeover rumors,pending litigation, valuable real estate holdings, a new patentapplication, an approaching retirement) can skew a stock's price and weakencomparability" (Bielinski, 199 , p. The pricing of initial publicofferings: A dynamic model with information production. This type of situation, however, does mean that issuingcorporations should identify and consider the nature of such bias when IPOpricing decisions are made. 34). 286). 65). Data "showing unusually high returns (12-21 %, net of market)accruing to IPO investors immediately after the offering have been cited asevidence that IPOs are substantially underpriced" (Zent, 199 , p. The CAPM was developed as a "simple, yet powerful description ofthe relationship between risk and return in an efficient market" (Sharpe,1999, p. References Allen, F., & Faulhaber, G. These IPOs generated $24.2 billion for the issuing corporations. (1988). On the plus side for the CAPM is the fact that it integrates theevaluation of investments with the capital market's valuation of the claimsagainst such investments (Sharpe, 153). The CAPM is based on the relationship between the risk of a specificsecurity and the overall risk of the market. Compare the relative performance and future outlook for theissuing corporation and the comparable public firms. Each of these securities are included in the marketportfolio in proportion to the market value of the volume of sharesoutstanding (Sharpe, 1999). Journal of Financial Economics, 24, 125-136. should be priced to give an expected return of market" (Sharpe, 1999, p.164). The investment banker selected tohandle a corporation's IPO should have experience with the industry inwhich the issuing corporation functions. Background Information on IPOs Investors are interested in IPOs because they "offer the prospect ofswift gains: a doubling of the share price on the first day of trading isnot uncommon" ("American IPOs: What Crash?" 1997, p. The valuation process for new private companies occurs in two phases.The first phase is the pricing evaluation. If the theoretical assumptions of the CAPM can be accepted, and ifvalues can be assigned to a risk-free rate of return and to the marketprice of risk, then the risk premium can be expressed as being proportionalto the expected rate of return on a market index (Sharpe, 1999). Chicago: The Dryden Press. representing alternative combinations of risk and returnobtainable by combining market portfolio with borrowing or lending" at therisk-free rate of interest (Sharpe, 1999, p. (1989). IPO pricing is crucial, because a price that is either too high ortoo low may cause investors to shun the issue. 142). (1992). Initial publicofferings. The comparable-firm approach is a four-step process. R. Investment banking and the capital acquisitionprocess. 149). 2. (1989). (1986). A fair price will enhance the probability that investors in the IPOwill realize gains both initially and over the longer-term, whilesimultaneously assuring the success of the IPO for the issuing corporation. The CAPM is used to determine the level of the market risk premium.The CAPM postulates that "in well-functioning capital markets the expectedrisk premium on each investment is proportional to its beta ... Chemmanur (1993) postulated that "insidershave private information about the quality of their firm's projects;outsiders may acquire information at a cost to reduce this informationasymmetry. Financial management. 149). Journal of Financial Economics, 23, 3 3-323. it impossible tocategorically measure risk and return and the relationship between them"(p. Retrieved fromthe Internet 2 - 4-28 at: http://www. Corporations preparing to issue an IPO receive advice on pricing frommany sources, including investment banks, underwriters, accountants,attorneys, and other entities (Krongard, 1996, p. 34). 1). Multiples should match only if the 'comparable'public company has identical prospects for growth and profitability,identical investment requirements and identical accounting procedures. The literature relevant to IPOs has established that IPOs of commonstock frequently are under priced ("IPO Scorecard," 2 ; Smith, 1986).This finding of systematic under pricing of equity IPOs led to thedevelopment of theoretical models designed to explain the existence of thephenomenon under equilibrium conditions. 165). J. Corporate CashflowMagazine, 11, 32-35. C. 6. (6th ed.). More recently, however, small investors are beginningto play a larger role in the success of IPOs ("American IPOs: What Crash?"1997). All investment strategies other than those combining market portfolioand the risk-free rate of interest in an optimal manner would be expectedto fall below the capital market line. The IPO pricing page. There are no taxes. But we will be extremely surprised if those future theoriesdo not still insist on the crucial distinction between diversifiable andnondeversifiable risk-and that, after all, is the main idea underlying theCAPM" (Brealey & Myers, 1999, p. Further, the investment analyst assigned by the investmentbank to an IPO issue should "be highly regarded by institutional investors"(Smith, 1994, p. 285). Sharpe (1999) said that, in the "fictional world of the CAPM, it is asimple matter to determine the relationship between portfolio risk andreturn" (p. 164). Even now, however, institutional investors remain the key to thesuccess of an IPO. 733). The capital market line develops the capital asset pricing model withrespect to portfolios. R. Journal of Financial and QuantitativeAnalysis, 13, 435-457. Signaling and the pricing of newissues. Beatty, R. All investors have identical subjective estimates of themeans, variances, and covariances of return among all assets. With respect to market pricing mechanisms, the valuation analysis mustprovide answers to three questions. The firm (or its insiders) sells stock in an IPO and again in asecond offering, made after trading begins in the secondary market.Insiders of high-value firms are motivated to maximize outsider informationproduction so that this information will be reflected in the secondarymarket price of their firm's equity, increasing its expected value.However, since information production is costly, only a lower IPO shareprice will induce more outsiders to produce information. Neither argumentis convincing, however, according the Zent (199 ), who holds that, in"efficient markets, only a fair return, not an extraordinary one, should berequired to earn the goodwill and attention of the financial community.Would there really be dozens of undersubscribed IPOs if investors no longerexpected abnormally high returns" (p. Financial Executive, 1 , 14-18. "Most consistently profitablecompanies tend to price off their P/E or price-to-cash-flow ratios, whileunprofitable or unpredictable firms tend to price off book value"(Bielinski, 199 , p. The Capital Asset Pricing Model (CAPM) frequently is used the assessthe equity value of a corporation issuing an IPO for purposes of pricingthe IPO (Zent, 199 ). Otherwise, the IPO may not be fully subscribed. Chief Executive, 119, 5 -53. (1989). Because a pricingrecommendation is biased does not mean that it is incorrect (Krongard,1996). A newer approach to the setting and evaluation of IPO pricing isshareholder value analysis (SVA). Goldberg, M. L., & Brigham, E. The "hot issue" market of 198 . Thefourth is incomplete markets (Maurer & Senbet, 1992). J., & Vetsuypens, M. H. Economist, 345, 83. Third, how do the current stockprices of each comparable firm compare to their historic prices? 149). (5th ed.). Muscarella, C. IPOs are equity stock issues whena corporation first initiates public trading of its shares. The results of this phase reflectthe actual worth of the new company based on the market's response to thecompany's initial public offering (IPO). 15). Not everyone agrees with the intentional under pricing approach forIPOs. Rock, K. Thepricing of an IPO affects directly the level of capital generated, theliquidity of the issuing corporation, and the enhancement of shareholdervalue. (1978, march). One analyst's estimates of risk and return for a security arelikely to differ from those of other analysts. Pricing an IPO. Smith, C. A decision criterion must be established to determine whether an IPO priceis either too high or too low. The first of these factors is the existence ofinformation asymmetry between market participants (Allen & Faulhaber, 1989;Grinblatt & Hwang, 1989; Rock, 1986; Welch, 1989). 285). 5. 4. In 1997 as an example, 469 IPOs had been floated in stock markets inthe United States through mid-November ("American IPOs: What Crash?" 1997). Underwriters typically advise that and IPO be priced approximately 1 percent below the projected post-offering price. Sharpe (1999) said that securities "prices are theresult of different analyses of somewhat different sets of information,along with different conditions and preferences relevant for variousinvestors. (5thed.). 32).Zent (199 ) acknowledged the arguments that some degree of under pricing isnecessary to "attract enough investors to an unknown entity" and becausesuch an approach to IPO pricing will cause investors to be "ready tosupport the issuer's subsequent capital needs" (p. If this paper is not what you are looking for, you can search again: Search for: or Click here to request an essay written just for you.