W14160

INITIAL PUBLIC OFFERINGS

Jeff Lindquist wrote this note under the supervision of Professors Colette Southam and Craig Dunbar solely to provide material for
class discussion. The authors do not intend to provide legal, tax, accounting or other professional advice. Such advice should be
obtained from a qualified professional.

This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the
permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights
organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western
University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) [email protected]; www.iveycases.com.

Copyright © 2014, Richard Ivey School of Business Foundation Version: 2013-05-13

This note provides an overview of Initial Public Offerings (IPOs) and addresses the methods used to value
companies undergoing an IPO. It begins with a brief introduction to IPOs and the rationale behind “going
public,” followed by an analysis of IPOs from the investor’s perspective. Next, the IPO process is outlined
and explained, including the underwriter choice, selling procedure, pricing and activities in the aftermarket.
Lastly, the note examines the valuation methodology used in the pricing stage of IPOs. This includes the
discounted cash flow method, the use of market multiples of comparable firms, as well as other situational
considerations when determining the initial price per share range and final offering price.

A BRIEF INTRODUCTION

An Initial Public Offering, as the name suggests, is the first sale of stock by a private company to the
public domain, which enables the stock to be traded on an exchange such as the New York Stock
Exchange (NYSE) or the Toronto Stock Exchange (TSX). A company will “go public” for a number of
reasons, such as to raise capital and to build a public profile.

Typically, IPOs are conducted by small, early-stage companies seeking capital to expand their businesses.
However, large privately owned companies looking to become publically traded might also conduct IPOs,
such as ING Canada (NYSE: ING) — the country’s largest property and casualty insurance company —
which went public in 2004 with an IPO that raised more than Cdn$1 billion . Sometimes large publically
traded companies will conduct IPOs to “spin off,” or monetize one of their existing subsidiaries. Wendy’s
International (NYSE: WEN) took this approach when it “spun off” Tim Horton’s through an IPO in 2006
worth nearly $660 million. 1 The proceeds of the IPO were used to repay debt owed to Wendy’s by the
subsidiary.

The company looking to go public (the issuer) will first attain the assistance of an investment bank (the
underwriter) to determine which type of security to issue to the public (common and/or preferred shares),
to conduct valuations to determine the best offering price and to make important decisions surrounding the
timing of the offering and selling strategy.

1
All currencies are in US$ unless otherwise stated.

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WHY IPO?

There are several strategic reasons for a company to conduct an IPO. Often, early-stage private companies
are started using an investment comprised of the founders’ own capital or funds raised from family,
friends, angel investors, venture capitalists and banks. As the company becomes established and grows in
size, going public through an IPO is a way for these early-stage investors to retrieve their initial
investments (with a substantial premium). This process is called monetization. The proceeds from the IPO
could also be used by the company to repay any banks that provided initial funding through small business
loans.

Going public is also a way for companies to attract media coverage and position their names and brands in
the public spotlight. Doing this increases brand recognition amongst the public, which could result in
increased future revenues and consumer loyalty. Putting a company in the spotlight through an IPO could
also attract other companies to evaluate it for potential mergers and acquisitions — a way to achieve
synergies and increase shareholder value.

Aside from the monetization strategy, companies may spin off a division of their enterprise through an IPO
to unlock the value of that piece of the company, which the market may not be taking into account.
Referred to as a conglomerate discount, the market has a tendency to undervalue large conglomerates
(companies made up of many subsidiaries such as General Electric). This theory suggests that the market’s
valuation of the conglomerate as a whole is less than the value of each of the subsidiaries combined, if
valued independently. A company can “unlock” its conglomerate discount by spinning off one or more of
its subsidiaries through an IPO, so that the market can recognize and account for their theoretical fair
values as pure play companies on a public exchange.

Finally, and perhaps most importantly, if the company issues new shares to the public through an IPO, the
company keeps the proceeds as cash and can use the funds for a multitude of purposes. From building new
factories and purchasing machinery to paying down debt and hiring new employees, companies can grow
and prosper by strategically allocating the cash proceeds of their IPO to where it’s most needed.

IPOS AND INVESTORS

When investors buy company shares through an IPO, the proceeds go directly to the company.
Subsequently, when they buy shares by trading on a stock exchange, the seller of those shares gets the
money in return. For the individual investor, IPOs can be a risky investment. It is very difficult to predict
how the stock will perform on the initial day of trading and in the near future following the initial offering.
This is particularly difficult primarily because most IPO firms are in transient growth periods and are
subject to uncertainty and risk, and secondly because there is often little historical data by which to analyze
the company and predict future cash flows.

Investors who are interested in rumours of certain IPOs in the marketplace can contact their brokers and
request to be notified of the coming offering. However, investors should be aware that IPOs are sometimes
“oversubscribed,” meaning that the public interest in the initial offering is so substantial that the number of
shares being offered to the public is far outweighed by the demand for them. In addition, the underwriters
in an IPO typically allocate large blocks of IPO shares to their best clients in advance of turning to the
public-at-large.

Oftentimes, investors who are lucky enough to get in on an IPO may only receive a small portion of the
shares they request as brokerage firms carefully ration the shares they have been allocated. If an investor

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misses out on an IPO, they must purchase the shares from the broader marketplace on the first day of
trading, when the price typically rises due to public interest, or sometime afterwards. When Google
(NASDAQ: GOOG) went public in 2004, raising proceeds of approximately $1.7 billion, the shares in the
IPO were priced at $85.00 each. However, this price was only paid by the investors who were a part of the
IPO. On Google’s first day of trading the share price jumped instantly to $100.00 per share, providing
significant capital appreciation for these initial public investors. IPO underwriters often frown upon
investors who “flip” oversubscribed IPOs by buying shares at the IPO price and then immediately selling
them on the first day of trading to earn a quick profit. Investors who behave this way develop negative
reputations and often find themselves excluded from future IPO share allocations.

THE IPO PROCESS

The IPO process usually requires about three months from start to finish, and private companies need to
fulfill several requirements before issuing equity for the first time. The company must: generate a credible
business plan; assemble a qualified management team; create an outside board of directors; prepare audited
financial statements, performance measures and projections; and develop relationships with investment
bankers, lawyers and accountants.

Selecting the Lead Underwriter and Underwriter Syndicate

The first step in the IPO process is for the company going public to hold “bake off” meetings to discuss the
equity-issuance process with various investment banks. The ultimate goal of these meetings is to select the
lead underwriter, the investment bank that will spearhead the IPO process and put together a syndicate – a
group of underwriters (investment banks) who will help distribute the newly created company’s shares to
the public.

The lead underwriter has a number of key responsibilities, including: providing procedural and financial
advice; valuing and pricing the IPO shares; buying the shares; certifying, marketing and reselling the
shares to the public; stabilizing the share price in the aftermarket; and providing ongoing research coverage
of the company. There are a number of important characteristics of a lead underwriter in the selection
process, including: proposed compensation package, analyst research support, distribution capabilities
(relationships with brokerages, institutional investors, etc.), the ability to provide aftermarket stabilization
support and, most importantly, the investment bank’s reputation and track record.

When selecting the lead underwriter, the issuing firm can examine where a particular investment bank
stands in the rankings by looking at the “league tables,” a scorecard of underwriters and how well their
deals have fared, published by financial journalists such as The Wall Street Journal and Thompson Reuters.
Most of these league tables are published every quarter, and the issuing firm can look at these rankings to
distinguish between top-flight investment banks, discount banks and anywhere between the two. The
investment banks with the highest prestige also charge higher fees. Typically issuing firms prefer to select
these banks as underwriters because of their established distribution networks, advanced research
capabilities, and the quality certification they provide to the newly issued shares by staking their
prestigious reputations on the line as the IPO’s lead underwriter.

Aside from the league tables, a firm can assess the reputations of their prospective underwriters by
examining their relative positions on “tombstones” — the advertisements announcing IPOs in financial
newspapers. The prestige ranking is based on the relative location of the investment bank’s name on the
tombstone, and is also influenced by the quality of the other underwriter names on the same tombstones.
Investment banks protectively guard their position in the tombstone hierarchy, and some banks have even

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been known to pull out of highly profitable deals because their desired position on the tombstone was
compromised. Despite the fact that these investment banks place so much focus on building and
maintaining their reputations, roughly one third of firms switch underwriters for their secondary equity
offering. Switching underwriters is not typically driven by dissatisfaction with underwriter performance
throughout the IPO process; rather it is driven by an effort to upgrade to a more prestigious investment
bank in order to attain improved research coverage.

An underwriter’s reputation can be deteriorated by inaccurately pricing the shares being offered.
Underwriters who substantially underprice shares in the offering are penalized, as they lose market share of
IPO deals in the marketplace. Established IPO underwriters have the most to lose in terms of market share
by severe underpricing, but can also damage their reputation with investors by overpricing — oftentimes
causing the deal to be undersubscribed. Failed offerings and excessive underwriter fees can further
deteriorate an underwriter’s reputation, while positive one-year stock performance post-offering and a step-
up in analyst quality and research coverage can enhance the underwriter’s reputation.

Organizational Meetings and the “Quiet Period”

After the issuing firm has satisfied the IPO requirements and has selected the lead underwriter, the equity-
issuance process begins with an organizational meeting attended by all the key participants, including firm
management, underwriters, accountants and lawyers. At this meeting, agreements are reached on specific
terms, such as the details within the IPO contract.

Now that the equity-issuance process has officially begun, the Securities and Exchange Commission (or
provincial regulatory body in Canada) prohibits the issuing firm from publishing information outside of the
prospectus — the marketing document containing all information required by the investor to make an
informed decision about whether or not to purchase the firm’s shares. Although the issuing firm is allowed
to continue with “business as usual,” such as normal advertising activities, it cannot create publicity to
raise awareness of its name or brands in order to create a favourable attitude toward the possibility of
owning shares. This legal requirement is known as the “quiet period.”

During the preliminary organizational meetings, the underwriters draft a “letter of intent,” which outlines
the terms and agreements of the IPO process but is not legally binding. Both the underwriters and the
issuing firm have the right to pull out of the agreement at any time before the offering date. The
underwriting agreement is not signed until the offering price is determined immediately before distribution
begins.

Contract Choice

An important part of the letter of intent is the detail surrounding the type of IPO contract: “firm
commitment” or “best efforts.”

Firm Commitment Contract

If the IPO contract is a firm commitment, the underwriters purchase all of the firm’s shares for an agreed-
upon price (“net proceeds”) and then attempt to resell the shares to the public at a slightly higher price,
which includes the spread — the underwriters’ compensation for executing the deal. Any shares that the
underwriters are unable to sell to the public are held for their own accounts. In the letter of intent, the

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underwriter will outline the spread they are to receive, any compensation necessary if the offer is
withdrawn by the firm and a “green shoe” provision (an overallotment option to sell as many as 15 per cent
more shares than stated in the agreement).

Next, the underwriters will begin the “due diligence” process, whereby they undergo an in-depth
examination of the proposed IPO candidate with the intention of producing a registration statement to
solicit the approval of the regulatory body. Due diligence includes reviewing company documents,
contracts and tax returns, as well as visiting company facilities and interviewing company auditors,
management and industry personnel. The registration statement contains information such as: a description
of the business, management and ownership structure; historical financial statements with an explanation
of the most recent results; and a discussion of the firm’s business strategy. The statement also includes a
tentative offering price range based on valuation methodologies, with the width of the range reflecting the
degree of certainty or uncertainty surrounding the theoretical fair value of the shares. The statement will
not disclose any information regarding the offering size or underwriter compensation. The performance of
due diligence is a very important piece of the registration process as it ensures that nothing in the
registration statement is significantly misleading or untrue.

Once filed with the regulatory body, the registration statement becomes the preliminary prospectus,
referred to as the “red herring” because of the red lettering down the left-hand side of the front cover. This
preliminary prospectus also includes details surrounding the use of the funds to be generated from the
offering, so that investors can measure the potential risks facing the business and be fully informed before
making an investment.

Based on the information contained in the preliminary prospectus, the issuing firm’s shares are now
marketed by the underwriter. Mailings of this information are sent to potential investors, and in-person
meetings are conducted through a “road show” in major cities across the country. This part of the process
is called the “book building” period, as the lead underwriter solicits nonbinding indications of interest from
large institutional investors. After receiving approval from the regulatory body prior to the IPO (typically
the day before), the lead underwriter sets a final price per share for the soon-to-be issued equity. The final
price selected may be within or outside of the range proposed in the initial prospectus. At this time, the
lead underwriter also determines the number of shares to be sold and decides if there should be a lock-up
option – a period of time when the initial public investors are restricted from selling their shares in the
open market to make a quick profit.

At this point, all parties sign the Underwriter Agreement and the final prospectus is printed, including a
“price amendment.” The underwriter syndicate guarantees to deliver all proceeds from the IPO (less the
spread) to the issuing firm regardless of whether the IPO is fully subscribed at the offering price. The lead
underwriter is in charge of determining allocations for various institutional investors and brokers and, in
the case of oversubscribed IPOs, rationing of shares occurs and the underwriter typically executes the
green shoe option. Oftentimes, the underwriters do not distribute shares randomly, but rather favour their
preferred investors by allocating them a large proportion of “hot issues” (significantly oversubscribed
IPOs).

Best Efforts Contract

A best efforts contract differs from the firm commitment contract in that the underwriters only agree to use
their best efforts to sell the issuing firm’s shares at an agreed-upon price per share and do not have to
undertake the expense of a road show. The underwriters do not commit to purchasing any unsold shares. In

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some scenarios, the best efforts contract is treated as “all or nothing,” in which case the offering is
withdrawn completely if all the shares being issued cannot be sold within a specific period of time. Some
IPOs with best efforts contracts have minimum numbers of shares that must be sold during a specified
period of time (usually around 90 days) for the offering to be completed. Smaller issuers typically use best
efforts contracts and, for the most part, any IPO raising more than $10 million exclusively uses firm
commitment contracts. Despite the fact that the underwriter does not take on the risk of having unsold
shares, best efforts contracts on average yield higher transaction fees than firm commitment deals. This is
accounted for by the economies of scale that are achieved with much larger issues, and the fact that most
underpricing occurs with best efforts offerings.

Selling Procedure

Fixed Price Offering Versus Book-Building

In an IPO that is a “fixed price” offering, the price per share is decided upon in advance by the
underwriters and the issuing firm, and sold to investors at that valuation. If the shares are sold through a
book-building process, the price per share is not yet decided upon, and the prospective investor is only
given an indicative range. With the fixed price offering, demand for the offering is not known until after
the closure of the issue, whereas with the book-building process the underwriters and firm can monitor
demand on a daily basis. The book-building method of selling dominates over the fixed price method of
issuance, except for in the smallest of offerings. Throughout the book-building process, investors are
enticed and encouraged to reveal their true beliefs about the issuing firm’s share price. However, unlike an
auction, book-building sets an upper limit where an auction does not. Some consider the book-building
method to be “unfair” to the small investor because allocations often favour large institutional investors.

IPO Auction as Selling Procedure

Although it has yet to gain a great deal of credibility in the North American business community, an
auction-styled IPO process does exist as an alternative selling procedure available to firms going public.
This method increases access to IPOs for small investors. The auction method of selling is conducted as a
private auction, and the highest bidders win (but all pay the same price). The bids are ranked in order from
highest to lowest, and the first bid price from the top that is enough to sell all of the offering’s shares is
identified as the offering price. Subsequently, each bidder who has offered at or above this selected price is
allocated a pro-rated number of shares for which they bid.

Underwriter Compensation

When conducting an IPO, a firm incurs direct costs such as taxes, legal and filing fees, and road show
expenses. However, the largest direct expense of the IPO is the underwriter’s spread. The commission paid
to the underwriter is directly related to the amount of risk taken on in the issue and, because of economies
of scale, is inversely proportional to the size of the offering. While the spread can range anywhere between
5 per cent and 10.5 per cent, most offerings have a spread around 7 per cent. There have been many
proposed explanations as to why the 7 per cent fee structure has persisted, including that uniformity
reduces the need for negotiation, and that when surveyed most executives rank fee structure lowest in
terms of what influences their choice of underwriter. This explains why underwriters typically do not
attempt to compete by offering lower fees – they are relatively unimportant to firms issuing equity. In
addition to the cash spread, underwriters can be compensated in the form of warrants to purchase stock at

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an exercise price that is expressed as a percentage of the offering price. Using warrants as compensation
typically lowers the overall transaction costs because it lowers the level of underpricing by the underwriter,
and serves as a signal to the marketplace that the offering is accurately priced.

While the compensation for underwriting an IPO can be quite lucrative for the investment bank, the
efficiency of the transaction from their perspective cannot be judged by looking at the spread received
from the single transaction. The investment bank invests a great deal in building a positive relationship
with the firm they are bringing to market in the hopes of securing investment banking business in future
transactions (such as mergers and acquisitions), as well as after market support, ongoing research and key
roles in secondary and subsequent equity offerings. Indeed, the investment bank’s success can be measured
by looking at the net proceeds of all transactions over the lifetime of its relationship with an individual
firm.

The Role of the Underwriter in the Aftermarket

The duties of the lead underwriter do not end on the day of the IPO. Aside from vying to receive future
contracts for investment banking business from the newly public firm, the underwriter continues to take an
active role as a market maker in the issue and often becomes the most active dealer. The underwriter can
take several measures to stimulate demand for and control supply of the newly public firm’s shares in the
aftermarket. These are called “stabilization activities.”

When demand is weak, the underwriter can take a “naked short position” in the form on an aftermarket
short covering. Prior to filing the final prospectus, the underwriter must decide if the short position will
exceed the 15 per cent provided for in the green shoe provision. To fight weakened demand, the
underwriter can exercise the green shoe provision and purchase the extra 15 per cent of shares and retire
them as if they had never been issued in the first place. Stabilization activities like this are necessary in an
IPO because it is feared that potential investors may renege on their orders. Even a few cancellations could
cause panic amongst all potential buyers, so this type of “price support” is needed. The supply of shares
can also be controlled by a “penalty bid,” where the lead underwriter takes back the compensation from a
broker who has allocated shares that have been flipped.

Monitoring “flipping” is another key role of the lead underwriter in the aftermarket. The immediate selling
of IPO shares in the aftermarket that were purchased at the IPO price is a controversial practice, sometimes
carried out by large institutional investors as well as small traders. Underwriters attempt to discourage
flipping by allocating shares to long-term investors and by punishing “flippers” by excluding them from
future oversubscribed offerings. Penalty bids are also an effective disincentive for brokers or clients to flip
shares.

Disadvantages of an IPO

One clear disadvantage of going public is that the issuing firm no longer has privacy and must report
endless details about its financial position and business strategy to the public. This is done quarterly and
annually through public reports issued by the corporation. In addition, the management team must now
answer to shareholders, the board of directors and analysts, and can be subject to scrutiny, pressure or even
criminal charges for not acting in shareholders’ best interests. There are other issues to take into account
before going public, such as loss of control for the original owners and the requirement to share financial
gains amongst all shareholders as a public company.

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DETERMINING SHARE PRICE FOR IPO

Throughout the IPO process, as detailed above, there comes a point when the underwriters must set an
initial share price range in consultation with the firm’s management. Determining the IPO price range and
final price is complicated and relies on both science and art. If the shares are underpriced significantly,
then the company is deprived of money it could have received through the offering (“money is left on the
table”). Overpricing shares is risky because weak demand could cause underwriters to have many shares
left over that nobody wants to buy. Ideally, the underwriters in the U.S. market aim to slightly underprice
the shares. Doing this will satisfy the firm by providing it with the majority of value that the market thinks
its shares are worth, and the underwriter’s investor clients are satisfied because they are getting the shares
at a slight discount to their theoretical fair value.

Underpricing is characterized by the pattern of positive initial returns of the stock (the percentage change
between the offering price and the closing price on the first day of trading). Research shows that around 70
per cent of all IPOs are underpriced, and only 16 per cent are accurately priced. Underpricing has been well
documented and, on average, IPOs are underpriced by approximately 15 per cent.

Standard practice for valuing IPOs is to use the comparable firm multiples method, whereby comparable
publically traded companies are identified and a variety of multiples are used to derive the issuing firm’s
theoretical fair value. This technique is then improved upon by applying forward-looking comparable
multiples to the firm’s projected operating statistics, and by adjusting the comparable company multiples to
account for leverage, growth and risk. Investment banking analysts working on IPO deals use their
judgment as well as a variety of rules when selecting the best multiple, such as placing more weight on
certain multiples for certain industries (i.e., the “price-to-book” multiple for valuing financial institutions).

As a second method to value the issuing firm, analysts will use the discounted cash flow (DCF) method.
This approach can be particularly difficult for IPOs because private companies looking to go public tend to
be small, young firms with unclear financial histories and they sometimes have negative earnings.
Nonetheless, deriving a “per share” value using this methodology is helpful to analysts as they estimate the
price range.

Once the price per share valuation range has been derived by using the above methodologies, the final
selected offering price is scrutinized and selected throughout the book-building process as new market
information is acquired and incorporated.

Market Multiples as the IPO Valuation Methodology

A common approach to pricing shares in an IPO setting is by using market multiples derived from
information based on publically traded companies similar to the issuing firm. The reasoning behind using
market multiples is to see at what price the market currently values certain comparable companies, based
on specific “valuation benchmarks,” or multiples. The selected multiple, used as the basis of valuation,
reflects something that is commonly valued by the market and is highly correlated with market value. For
example, because EBITDA (earnings before interest, tax, depreciation and amortization) is considered a
proxy for annual cash flow, the multiple of Total Enterprise Value to EBITDA (TEV/EBITDA) is
commonly used. Likewise, because Earnings per Share (EPS) is a very important value driver of public
companies, the multiple of Price to Earnings (or “PE Multiple”) is used to derive value using the
correlation of Share Price/EPS.

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Forward Multiples (ones that are based on projected data) are more valuable measures for deriving value
than Trailing Multiples (multiples based on past, or Last Twelve Month data). Oftentimes, when forward
multiples are not available or reliable, analysts will multiply trailing multiples by forecasted data to derive
a value. Some analysts argue that the disadvantage of using estimated multiples outweighs the advantage
of being forward-looking, while others support this substitute for forward multiples. That being said, the
common best practice is to calculate as many values as possible using both trailing and forward (or
estimated) multiples, and use the valuation that makes the most sense.

Lastly, once a multiple has been selected and before multiplying it by the issuing firm’s operating statistic
to derive a value, some analysts will adjust the multiple to account for growth and risk. For example, if the
TEV/EBITDA multiple of a comparable company is 8x, and the issuing firm is notably more risky (i.e.,
much more highly levered), then the multiple may be adjusted downwards. This is because the market
values companies with less risk and more growth opportunities at higher multiples than comparable firms
with more risk and less growth.

Steps to Follow:

The first step in estimating a private firm’s value using market multiples is to select the appropriate
comparable companies. The key indicators to look for are:

• Industry
• Size (Sales and/or Assets)
• Growth
• Risk
• Leverage
• Operations
• Geography

Once the comparable company or companies have been selected, the value of the issuing firm can be
derived by multiplying the selected market multiple of the comparable company by the relevant operating
statistic. For example:
Comparable Issuing
Multiple X Firm = Issuing Firm Equity / Shares = Share
Statistic Value Value Issued Price

TEV/EBITDA X EBITDA = Total Enterprise = Equity /Shares = Share

Value Value Issued Price
- Net Debt

PE Multiple X Net  = Equity /Shares = Share

Income Value Issued Price

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Remember to consider adjusting the multiple if necessary, and also make decisions regarding trailing
versus forward multiples and which operating statistic you wish to use to derive the issuing firm’s value.

Discounted Cash Flow (DCF) as the IPO Valuation Methodology

The DCF approach to valuation attempts to determine the value of the issuing firm in an IPO setting by
calculating the present value of cash flows over the life of the firm. The analysis is broken down into three
parts: the calculation of the company’s weighted average cost of capital (WACC); the estimation of free
cash flow forecasts for the foreseeable future (until the abnormal growth period has subsided, but we will
assume five years for simplicity in this note); and the estimation of a terminal value in the last year of the
forecasted future to capture the present value of all future cash flows beyond that period. In the second and
third parts of the analysis, the estimated cash flows are all discounted back to presented value using the
WACC, which is the discount rate in the DCF analysis. The sum of the present value of the future cash
flows of the firm is called the “total enterprise value.” From this value an analyst can subtract the firm’s
“net debt” (all interest-bearing debt less unallocated assets such as cash) to find the firm’s equity value. In
an IPO setting, the analyst would then be able to estimate the share price of the issuing firm by dividing the
equity value by the estimated number of shares to be distributed to the public.

Weighted Average Cost of Capital (WACC)

The WACC is the investor’s weighted average opportunity cost on comparable investments to that of the
issuing firm. The WACC must incorporate the target weights of financing going forward post-IPO (debt
vs. equity). The appropriate discount rate is a blend of the required rates of return on debt and equity,
weighted by the proportion each of these sources of capital will make up in the firm’s capital structure
post-IPO.

WACC = W d *K d (1-t) + W e *K e

Where,

K d = the current required yield (yield to maturity) on debentures or bonds or interest rate on bank debt

K e = the cost of equity, as calculated using the Capital Asset Pricing Model (CAPM)

W e / W d = the target percentages of debt and equity in the issuing firm’s projected capital structure

t = the marginal tax rate

The cost of equity can be found using the Capital Asset Pricing Model (CAPM):

K e = R f + ß*(MRP)

Rf = the expected return on risk-free government securities over a time period consistent with the
investment horizon. Most analysts will use the 10-year government bond rate.

MRP = the market risk premium, or in other words, the excess return an investor should expect for
choosing to invest in the public market rather than a risk-free government security. The value is

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often estimated as the average historical difference between returns on common stocks (as
represented by an index such as the S&P500) and the returns on long-term government bonds. In
the past, analysts have typically used 5 per cent as an estimation of the MRP. However, due to the
tumultuous markets of the past decade, many researchers and analysts alike believe this premium
is too high. Some argue that the market risk premium should be in the 21/2 per cent to 4 per cent
range, but nonetheless it is up to the analyst performing the valuation to use the estimate with
which they feel most comfortable.

ß= the beta of the issuing firm, which is a measure of the systematic risk of the firm’s stock.
However, because the issuing firm has not yet gone public, it does not have any stock from which
an analyst can find a beta. To solve this problem the analyst will “borrow” the beta of a
comparable public company, unlever the beta to take away the impact of the comparable firm’s
capital structure, and then relever the beta at the issuing firm’s target capital structure. This new
“relevered” beta can now be used in the CAPM equation to estimate the issuing firm’s cost of
equity.

Unlever the Beta: ß U = ß L / [1 + (1-t) * D/E]

• D/E is the comparable public firm’s debt-equity ratio

• t is the tax rate of the comparable firm
• ß L is the comparable public firm’s beta (as found on Bloomberg)
• ß U is the comparable public firm’s beta less the impact of their capital structure

Relever the Beta: ß L = ß U * [1 + (1-t) * D/E]

• D/E is the target debt-equity ratio of the issuing firm

• t is the tax rate of the issuing firm
• ß U is the comparable public firm’s unlevered beta
• ß L is the new estimated beta of the issuing firm, used in the CAPM equation

Free Cash Flows Forecast

The free cash flows in an IPO valuation analysis are the expected operating cash flows before the
consideration of financing charges over the foreseeable future. On many occasions, there is only enough
information about the firm to project five years of cash flows, however, the foreseeable future may be
cloudier in an IPO analysis because many issuing firms have incomplete financial histories from which to
base future projections, or even negative earnings.

FCF = EBIT*(1-t) + Depreciation - CAPEX - ∆NWC

• EBIT is the issuing firm’s expected earnings before interest and taxes, which is then multiplied by (1-t)
because tax is a cash expense each year
• Depreciation is non-cash operating charges including depreciation, depletion and amortization
recognized for tax purposes
• CAPEX is the projected capital expenditures for fixed assets for the projected year
• ∆NWC is the increase in net working capital, defined as current assets less the non-interest bearing
current liabilities

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The cash flow forecast should be consistent with the industry and macroeconomic trends, as well as the
firm’s strategy, competitive pressures and management guidance. Once the free cash flows have been
projected for the foreseeable future, a terminal value must be calculated.

Terminal Value

The terminal value reflects the present value of future cash flows occurring beyond the projection period
and can be calculated using two different methodologies: the perpetuity growth model approach or the
terminal multiple approach. With the perpetuity approach, the terminal value is calculated using the last
year free cash flow in the forecast period. Since it accounts for all cash flows occurring after the last year
in the forecast period, it is typically a large component of the valuation, and should therefore be given
thoughtful consideration. This is particularly important in early-stage high growth companies where free
cash flows in the initial years of the forecast period are negative due to aggressive growth through capital
investment.

Terminal Value (TV) = [FCF last year *(1 + g)] / (WACC – g)

• FCF last year is the expected free cash flow in the last year of the cash flow forecast
• g is the expected constant annual growth rate of the firm in perpetuity. This rate is estimated using
current nominal GDP expectations (inflation of 2 per cent + real GDP growth of 1 per cent to 2 per
cent) to give a value that is usually between 3 per cent to 4 per cent
• WACC is the weighted average cost of capital of the issuing firm

The terminal multiple method uses a market multiple to calculate a value for the firm at the end of the
projection period. TEV/EBITDA is a commonly used terminal multiple. As with market multiple
valuations, the analysis of comparable firms will provide an appropriate range of multiples. The multiple is
then applied to the projected EBITDA in year five (or year six) in the projection period, which provides a
future value at the end of year five (or year six).

Calculating Total Enterprise Value

Now that free cash flows have been estimated for the foreseeable future, and a terminal cash flow has been
estimated for the future beyond the forecasted future, these cash flows must be discounted to present value
using the WACC as the discount rate. In the case of a five-year forecast period, the equation would be as
follows:

Total Enterprise Value = FCF 1 /(1+WACC)1 +…+ FCF 5 /(1+WACC)5 + TV/(1+WACC)5

Remember that the analyst must then subtract the issuing firm’s net debt from the estimated Total
Enterprise Value to find the firm’s Equity Value. The Equity Value can then be used to derive a share price
range by dividing by the post-money number of shares outstanding.

Selecting the Final Offering Price

After analysts have calculated a number of share price values using the market multiples method and the
DCF approach (as well as some additional valuation methodologies beyond the scope of this note), a final

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share price range can be developed and communicated to company management and potential investors by
constructing a football field valuation. When building the valuation, analysts must narrow the range by
deciding in which valuation methodologies they have the most confidence. For example, analysts valuing
an early-stage company with uncertain future cash flow projections might lean away from the DCF
valuation range and give more weight to the values derived using market multiples.

Company X Football Field Valuation

Yield 5.77 10.01

DCF 7.75 15.83

EV/FFO 10.01 18.36

TEV/EBITDA 5.10 9.95

DDM 8.71 13.46

NAV 6.84 8.36

$10.50
Expected price 8.14 9.95

$0.00 $5.00 $10.00 $15.00 $20.00 $25.00

The football field valuation acts as a springboard for negotiations and discussion between the investment
bankers, company management and investors throughout the road show process. Although a narrow share
price range is typically decided upon by analysts before the road show begins, the reaction at the road show
is always incorporated into the final pricing. Analysts can be fully certain that their valuation range is as
fair as can be, but if general sentiment throughout the road show is that investors believe the shares are too
expensive then downward adjustments must be made so that the IPO will be fully subscribed. However, in
this scenario company management may step in if they believe the final offering price will be too low to
generate adequate proceeds, and cancel the IPO all together. Likewise, throughout the road show investors
may show a high level of demand for the company shares, allowing analysts to increase the final offering
price. Of course, this latter scenario is most desired by company management as they hope to raise as much
cash as possible by the final offering stage in the IPO process.

This document is authorized for use only in Prof. Nalini G S's Company and Business Valuation 8.4.2021 at Thiagarajar School of Management (TSM) from Aug 2021 to Jan 2022.