Capstone Project 2017 - 19

Title of the Project: A Case Study Analysis – IPO

Accuracy of JP Morgan Chase & Co and Goldman
Sachs

Submitted by:
Faculty Guide: Prof. Geetanjali Pinto Name of the Student: Sohon Chowdhury
Designation: Professor Roll No: 1719PGDM1142
Program: PGDM
Batch: 2017-19

Institute for Technology and Management

Plot No. 25 / 26, Institutional Area,
Sector – 4, Kharghar, Navi Mumbai
This is to certify that the Project Work titled
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work carried out by Mr. / Ms.

(name of the student) Roll No. ______________________, a student of PGDM program 2018

– 2020 of the Institute for Technology & Management, Kharghar, Navi Mumbai under my

guidance and direction.

Signature of Guide : __________________________

Name of Guide : ____________________________________________________

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Date: _____________ Place: ________________

 Abstract

We investigate the valuation and the pricing of initial public offerings

(IPOs) by investment banks for a unique dataset of 49 IPOs on
Euronext Brussels in the 1993–2001 period. We find that for each IPO
several valuation methods are used, of which Discounted Free Cash
Flow (DFCF) is the most popular. The offer price is mainly based on
DFCF valuation, to which a discount is applied. Our results suggest
that DDM tends to underestimate value, while DFCF produces
unbiased value estimates. When using multiples, investment banks
rely mostly on future earnings and cash flows. Multiples based on
post‐IPO forecasted earnings and cash flows result in more accurate
valuations.
 1. Introduction

1.1 General Overview of the sector

The financial services industry leads the world in terms of earnings

and equity market capitalization. Large conglomerates dominate this
sector, but it also includes a diverse range of smaller companies.

Commercial banking services form the foundation of the financial

services group. The operations of a commercial bank include the
safekeeping of deposits, issuance of credit and debit cards, and the
lending of money.

An investment bank typically only works with deal makers and high-
net-worth clients, not the public. These banks underwrite deals, secure
access to capital markets, offer wealth management and tax advice,
advise companies on mergers and acquisitions, and facilitate the
buying and selling of stocks and bonds.

Financial Advisers and discount brokerages also occupy this niche.

There are also software vendors that cater to the investment fund
community by developing software applications for portfolio
management, client reporting and other back office services.

Insurance is another important subsector of the financial services

industry. The vast financial services sector also includes accountants
and tax filing services, currency exchange and wire transfer services,
and credit card machine services and networks. It also includes debt
resolution services and global payment providers such as Visa and
MasterCard, as well as exchanges that facilitate stock, derivatives and
commodity trades.
1.2 Problem on Hand

Investment banking is the business of raising capital or trading for

customers. Companies need cash in order to grow and expand their
businesses (initial public offering); investment banks are firms who
sell securities to public investors in order to raise this cash. These
securities can come in the form of stocks or bonds.

A firm conducting an initial public offering (IPO) needs to have its

stock valued before the IPO, in order to determine a price range
within which the stock will be offered to the public. There are several
methods available for stock valuation. The most widely used valuation
approaches are the dividend discount model (DDM), the discounted
free cash flow (DFCF) method, and valuation approaches that rely on
multiples of firms in similar industries and firms involved in similar
transactions.

While there is a very extensive literature on IPOs, and there are many
papers on the choice and accuracy of valuation methods, few papers
focus on the valuation of IPOs.

1.3 Importance of the Problem

An IPO, or an initial public offering, is a way for a private company to

raise capital for operations and growth by selling shares of the
company to the public. But how does a business determine how many
shares it should sell and at what price? In other words, how does a
business determine its own value on the open market? For this,
companies turn to investment banks for valuation. The valuation of an
IPO is a delicate affair. If the stock is undervalued, the company can
leave huge amounts of money on the table while the initial investors
make enormous profits from selling the undervalued stock. If the
stock is overvalued, the underwriting investment bank often needs to
step in and buy up shares to shore up the price, investors lose money,
and the stock could tailspin as investors try to dump shares.
1.4 Scope of the Project

We are aware of only one study that investigates the choice of

valuation methods for IPOs, and two studies that focus on the
accuracy of IPO valuation.1Roosenboom (2007) investigates how
French underwriters value the stocks of firms they take public, and
finds that the valuation methods used depend on IPO firm
characteristics, aggregate stock market returns and stock market
volatility. Kim and Ritter (1999) value a sample of IPOs in the US
using price‐earnings (P/E) and price‐to‐book comparables, and find
that these methods lead to very imprecise valuations when historical
accounting numbers are used. However, when forecasted earnings are
used, the accuracy of the valuation improves substantially. Berkman,
Bradbury and Ferguson (2000), who value 45 newly listed firms in
New Zealand, conclude that the best discounted cash flow and P/E
valuations have similar accuracy.

An important feature of existing studies on the accuracy of IPO

valuation methods is that they use ex post value estimations by the
researcher(s). In Belgium, pre‐IPO value estimates by the lead
underwriting investment bank are often published in the IPO‐
prospectus, which is made available at the start of the public offering.
Until recently, the Banking, Finance and Insurance Commission, the
supervising authority for Belgian financial markets, requested that this
information should be included in the prospectus for domestic public
offerings. In most other countries, this information is not publicly
available. Furthermore, even in Belgium, this is not the case anymore
due to the ‘Prospectus Directive’ (Directive 2003/71/EC), which had
to be transposed into national law by all EU member states before July
1, 2005. In all member states, the IPO prospectus will need to comply
with international standards, and a section on the company's
valuation/justification of the pricing will not be included anymore.

The availability of this information in Belgian prospectuses allows us

to examine how IPOs are valued, and how this valuation affects the
pricing of IPOs. It can be expected that the accuracy of ex ante
valuation by investment banks will differ from the valuation accuracy
measured by academics, for several reasons. Value estimates by
investment banks may be less accurate because academics are more
objective than investment banks, who may be tempted to report
valuations that justify a high price, for instance by choosing
comparables with high multiples, or a low price, in order to reduce
marketing efforts. On the other hand, value estimates by investment
banks may be more accurate than value estimates by academics
because investment banks have more information for valuation
available. Moreover, as the stock market is pricing perceptions of the
future and not the future itself, the value estimates by lead
underwriters and the offer price, which to some extent will be based
on these value estimates, may influence these perceptions and
therefore the stock price. However, in an efficient market mispricing
by underwriters should not affect market valuation.

In this paper, we investigate the valuation and pricing by the

underwriters of 49 IPOs on Euronext Brussels (formerly the Brussels
Stock Exchange) in the 1993–2001 period. We address two research
questions. First, we want to know how IPOs are valued. What
valuation models do underwriters use, and how do they set the offer
price, given the value estimates? Second, we investigate which of the
valuation models, as used by underwriters, provides the best
estimation of the stock market price. Do these valuation methods
produce unbiased results, and what is the accuracy of the valuations?
We find that for each IPO several valuation methods are used, of
which DFCF is the most popular method: the DFCF model is used to
value all IPOs in the sample. We also find that the offer price is set
closer to DDM estimates if DDM is applied. This is remarkable, as a
comparison of pre‐IPO valuations to the average stock price in the
first month of listing and to the stock price on post‐IPO days +1, +10,
+20 and +30 suggests that DDM tends to underestimate value, while
DFCF produces unbiased results. Interviews with investment bankers
indicate that underwriters consciously underprice IPOs, by applying a
deliberate discount to DFCF value estimates. DFCF is considered to
be the most reliable method. DDM estimates are on average closer to
the preliminary offer price than other value estimates, because DDM
tends to underestimate value. Furthermore, we find that P/E and
price/cash flow (P/CF) multiples using earnings and cash flows in the
IPO‐year lead to less accurate valuations than multiples using
forecasted earnings and cash flows in the year after the IPO, which is
consistent with results of Kim and Ritter (1999). Finally, our results
indicate that the final offer price is closer to the stock market price
than pre‐IPO value estimates. This is consistent with the expectation
that the final offer price incorporates valuable information about
investor demand, obtained by the underwriter during the public
offering.

This paper makes two contributions to the literature. First, it explores

the frequency of use of alternative valuation models within the IPO
pricing context, providing evidence that changes the consensus in the
valuation model choice research area. Our finding that DFCF is the
most popular valuation model contrasts with previous work, which
shows that financial analysts primarily focus on multiples and tend to
ignore discounted cash flow models (e.g., Block, 1999; Barker, 1999a
and 1999b; Bradshaw, 2002; Demirakos et al., 2004; and Asquith et
al., 2005). We put forward various possible explanations for the
extensive use of DFCF in our sample. First, there may be a lack of
comparable firms, which makes methods based on multiples difficult
to implement. Second, there may be differences in the perceived
importance that investment banks attach to alternative valuation
techniques. A third reason may involve time‐specific effects: the
majority of our sample went public at the end of the 1990s, a period of
very high stock market levels during which the use of multiples might
have led to overvaluation. Finally, differences in the quality and
objectives of IPO prospectuses and equity research papers may
account for our finding.

The second contribution is that the paper uses ‘real world’ estimations
to investigate the accuracy of valuation models within the IPO pricing
context, in contrast to Kim and Ritter (1999) and Berkman, Bradbury
and Ferguson (2000) who use ex‐post value estimates by academics.
Some studies examine the accuracy of earnings forecasts in IPO
prospectuses, but do not focus on valuation accuracy (e.g., Firth and
Smith, 1992; Jaggi, 1997; Jelic, Saaudouni and Briston, 1998; Cheng
and Firth, 2000; Gonoupolis, 2003; and Jog and McConomy, 2003).
Other papers (e.g., DeAngelo, 1990, for management buyouts)
investigate the ‘real world’ use of valuation models in different
settings but do not discuss valuation accuracy.

This paper is closely related to Roosenboom (2007), who investigates

how French underwriters value the stocks of firms they bring public.
Our paper complements and extends the work of Roosenboom in
several respects. First, while the study of Roosenboom specifically
focuses on how IPOs are valued, we also offer empirical evidence on
the accuracy and bias of the implemented valuation methods. Second,
we provide much more detailed information about multiple valuation,
whereas Roosenboom combines all multiple valuation methods into
one single group. Third, we use interviews to interpret the quantitative
results and explain the relation between the estimates derived by
alternative valuation models and the preliminary offer price. Fourth,
while Roosenboom investigates the French stock market, our study
offers empirical evidence on the valuation of IPOs for another, smaller
stock market. Our findings reveal some interesting differences as
compared to Roosenboom. Contrary to Roosenboom, we find that
DFCF and not multiples is the most important valuation model. Our
results also suggest that investment bankers base the preliminary offer
price primarily on DFCF regardless of the characteristics of the
analyzed firm. The preliminary offer price is derived by applying a
discount to the DFCF valuation estimate.2

The remainder of the paper is organized as follows. In the next section

we briefly discuss the choice and accuracy of valuation models.
Section 3 describes the IPO process in Belgium. The sample and the
methodology we use are discussed in Section 4. In Section 5 the
valuation outcomes are compared to the IPO offer price and the
average stock market price in the first month of listing. Section 6
discusses the relation between IPO valuation and underpricing.
Finally, Section 7 presents some conclusions.
https://www.chittorgarh.com/report/ipo_prospectus_document_drhp_r
hp_pdf/20/