IPO Valuation Explained

Somewhere in every red herring prospectus sits a short section titled Basis for the Issue Price. It is usually a handful of pages, it contains almost no narrative, and it is the closest thing an investor gets to an explanation of how the company and its bankers arrived at the number you are being asked to pay. Most retail applicants never open it. That is unfortunate, because the section is where the valuation argument is made, and once you know how to read it you can judge whether the argument holds together.

This guide is about that argument. It covers the mechanics that turn a company into a per-share price, the share-count subtleties that quietly change every ratio, and the reason the resulting band should be read as a proposal from a seller rather than an independent verdict on worth. It does not evaluate any particular issue and it does not tell you whether a price is fair, because that depends on judgements only you can make.

The one idea that makes everything else make sense

A valuation exercise has two separate steps that are easy to blur together. First you estimate what the whole business is worth. Then you divide by the number of shares to get a price per share. Almost every confusing thing about IPO pricing comes from something happening in one of those two steps that the reader did not notice.

The reason the second step matters so much in an IPO is that the share count is changing at the exact moment the price is being set. A fresh issue creates new shares, so the number you divide by after the issue is larger than the number before it. Our guide on fresh issue versus offer for sale explains which part of an offer creates new shares and which part merely transfers existing ones, and that distinction feeds straight into the arithmetic below.

Earnings multiples: the method you will see most often

The price-to-earnings ratio is the workhorse of Indian IPO pricing disclosures. It compares the price of one share to the earnings attributable to one share. Take an illustrative company that reported a profit after tax of 60 crore rupees and has 6 crore shares. Earnings per share is 10 rupees. If the cap of the price band is 250 rupees, the issue is being offered at 25 times earnings. These numbers are invented to demonstrate the calculation.

A multiple by itself means nothing at all. Twenty-five times is expensive for a business whose profits are flat and cheap for one compounding quickly, and the honest reading of any P/E is that it encodes an expectation about the future. What the offer document gives you is the number; what it cannot give you is confidence that the expectation embedded in it is reasonable. That judgement comes from the financial statements, the risk factors and the competitive picture.

The prospectus usually presents the ratio at both the floor and the cap of the band, and computes it on more than one earnings basis. Read which year's earnings sit in the denominator. A ratio computed on the most recent full year says something different from one computed on a three-year weighted average, and a company with a sharply improving profit trend will look cheaper on the recent year while one with a deteriorating trend will look cheaper on the average.

Pre-issue and post-issue: the same company, two different EPS numbers

This is the technical point most worth understanding, and it is where a lot of casual analysis goes wrong. Continue the illustration. The company has 6 crore shares before the issue and earned 60 crore rupees, so pre-issue EPS is 10 rupees. Now suppose the IPO includes a fresh issue that creates 1.5 crore new shares. After listing there are 7.5 crore shares. If profit stayed exactly the same, post-issue EPS would be 60 divided by 7.5, which is 8 rupees.

At a 250 rupee cap, the pre-issue P/E is 25 while the post-issue P/E is 31.25. Same company, same profit, same price, two very different-looking multiples. Neither is dishonest; they answer different questions. The pre-issue figure asks what you are paying relative to the earnings the existing business generated. The post-issue figure asks what you are paying relative to those earnings spread across the enlarged share base you will actually own a slice of.

There is a fair counter-argument, and it is worth stating. The fresh issue brings cash into the company, and that cash is meant to fund growth, repay debt or reduce interest cost. So holding profit constant while raising the share count understates what should happen next. That is exactly why the objects of the issue deserve reading: they tell you what the new money is supposed to do, and whether it plausibly generates the additional earnings needed to justify the larger denominator. If the offer is predominantly an offer for sale, the company receives none of that money, and the growth argument has to come from somewhere else.

• Check whether a quoted P/E is on a pre-issue or post-issue share count before comparing it with anything.
• Check whether the EPS is basic or diluted; outstanding employee options and convertible instruments enlarge the diluted count.
• Check the period: latest full year, a stub period annualised, or a multi-year weighted average.
• Check whether earnings are restated consolidated figures, which is the standard basis in Indian offer documents.
• Check whether any one-off item, such as a gain on sale of an asset or a tax credit, is inflating the denominator year.

When earnings are not the right yardstick

Plenty of companies come to market with thin profits or none at all, and a P/E computed on a tiny or negative number is meaningless. Offer documents in these cases lean on other measures, each with its own logic and its own blind spot.

• Price to sales, or enterprise value to revenue, compares the price against the top line. It works when revenue is real and growing but says nothing about whether that revenue can ever be turned into cash.
• Enterprise value to EBITDA adds back interest, tax, depreciation and amortisation. It makes capital-heavy businesses comparable across different debt loads, but it flatters companies whose depreciation reflects genuine, recurring asset consumption.
• Price to book value compares price against net assets on the balance sheet. It is the conventional lens for banks and other lenders, where the balance sheet is the business, and close to useless for an asset-light services firm.
• Market capitalisation to net worth, and various return ratios such as return on net worth, appear frequently in Indian offer documents alongside the multiples.
• Discounted cash flow builds a value from projected future cash flows. It is intellectually the most complete method and the most sensitive to assumptions, which is why it rarely appears as the headline justification in a prospectus.
• Sector-specific operating metrics, such as value per subscriber or per unit of capacity, show up in industries where accounting profit lags the economics.

The pattern to notice is that the choice of metric is itself a choice about what to emphasise. A loss-making company will naturally prefer a revenue multiple. A company with heavy depreciation will prefer EBITDA. None of that is improper, and the offer document discloses which measures it is using. But it means the metric set is not neutral, and reading it as though it were is a mistake.

Why the band is a proposal, not an appraisal

Here is the structural fact that shapes everything else. The price band is proposed by the issuing company in consultation with the lead managers it appointed and pays. There is no independent valuer whose job is to tell the public what the shares are worth. The regulator reviews disclosure, not price: the requirement is that the basis for the price be explained honestly and completely, not that the price be endorsed as correct.

The incentives on each side of the band are worth spelling out because they are not symmetric. Selling shareholders and the company want the highest price the market will bear, since a higher price means more money raised or a better exit. But pricing too high risks a poorly subscribed issue, which is expensive and embarrassing for everyone involved, so the band is usually set with some room left. That produces a number arrived at through negotiation and market feedback, which is a legitimate way to price something, but it is a seller's proposal all the same.

“A price band tells you what the seller is asking. Working out what the business is worth remains the buyer's job.”

It also helps to remember that a book-built issue does not settle on a single number until bidding closes. The band opens the conversation and the demand across investor categories determines where inside it the price lands. Our guides on the price band and on subscription data cover that discovery process in detail.

Reading the Basis for the Issue Price section

The section follows a broadly predictable shape, which makes it easy to work through methodically once you have seen it a couple of times. It opens with qualitative factors, moves to quantitative ones, and closes with a comparison against listed peers.

1. Read the qualitative factors first, but read them as marketing rather than evidence. They are the company's own description of its strengths.
2. Move to the quantitative factors and note every ratio disclosed, along with the basis of each one.
3. Reconcile the EPS figures against the restated financial statements elsewhere in the document. They should tie out.
4. Note the share count used and confirm whether it is pre-issue, post-issue, basic or diluted.
5. Look at the peer comparison table and identify who was chosen and, more revealingly, who was not.
6. Cross-check against the objects of the issue: is the money funding growth that supports the multiple being asked for?
7. Read the related risk factors, which often contain the frank version of the concerns that the qualitative factors gloss over.

The peer table deserves particular scepticism, and it has its own guide in this pack because the choice of comparison companies can quietly do most of the persuasive work in a valuation argument. A company placed against expensive peers looks reasonable; the same company placed against cheaper ones looks stretched.

Sanity checks you can run yourself

You do not need a valuation model to test whether a price band is internally consistent. A few arithmetic checks catch most of the loose reasoning.

• Compute the implied market capitalisation: cap price multiplied by post-issue share count. Then ask whether a business of this size, in this industry, plausibly carries that valuation.
• Rebuild the P/E yourself from the restated profit and the post-issue share count rather than trusting a headline figure from a news summary.
• Look at what the multiple implies about growth. If the market typically pays a certain multiple for stable businesses, a much higher one is a bet on a specific growth rate; ask whether the financials support that rate.
• Check the trend in profit rather than a single year. A single unusually strong year in the denominator can make an expensive price look moderate.
• Separate the fresh issue from the offer-for-sale portion and note how much of what you pay actually reaches the company.
• Compare the issue price with the price at which shares were allotted in the months before the IPO, which the capital structure section discloses.

That last check is often the most instructive and the most misused. A pre-IPO placement or a preferential allotment at a much lower price does not automatically mean the IPO is overpriced. Those transactions may have happened earlier, at a smaller scale, with illiquid shares and different rights attached. But an unusually large gap deserves an explanation, and the document generally offers one.

What valuation cannot settle

Even a careful valuation exercise leaves a lot open. It does not tell you what the share will do on listing day, because that depends on demand from people who may not have read the prospectus at all. It does not account for grey market chatter, which is an unofficial and unregulated indicator rather than a valuation input. And it does not remove the possibility that a well-analysed, sensibly priced business simply performs worse than expected.

The realistic goal is narrower and more achievable: understand what you are paying for a claim on a stream of earnings, understand the assumptions embedded in that price, and know which of those assumptions would have to fail for the investment to disappoint. That is a description of informed participation, not of certainty, and no amount of analysis converts one into the other.

Finally, treat every figure in this article as a method rather than a fact. Accounting standards, disclosure requirements and the format of the offer document evolve. Confirm the current requirements and the specific numbers with SEBI, the exchange, and the latest filed offer document for the issue you are examining.