Department of Finance

College of Business
University of Illinois at Urbana-Champaign
Prof. George Pinteris
Finance 322 Fall 2003

Notes on Initial Public Offerings and Firm Valuation

This handout reviews the process of raising capital by firms. Firms can raise
capital either through private sources, such as venture capitalists or private equity
investors, or by accessing the financial markets either through an initial public offering
(IPO) or by raising additional financing after having become publicly traded. We will
examine the firms financing choices and discuss the IPO process. A main issue in this
process is the pricing of the firms shares. Thus, we will also consider a number of widely
used approaches for stock and firm valuation.
A Firms Financing Choices
Firms that want to pursue projects with positive NPVs are faced with two general
financing choices: internal or external financing. Internal financing refers to the retained
cash flows (retained earnings) that are generated by a firms assets. Evidence from US
non-financial firms during the past 25 years shows that they meet almost 70% of their
financing from internal sources. External financing refers to outside sources of funds that
can be either private or raised in financial markets. This type of financing can, in general,
be either in the form of debt or equity. Due to increased financial innovation, hybrid
securities that have both debt and equity features, such as convertible bonds or warrants,
have become financing alternatives for many firms in recent years. For example, a
convertible bond has the feature that it can be converted into a predetermined number of
common shares at the discretion of the bondholder. Even though there exists a wide range
of financing choices (instruments) in economies with advanced financial systems, such as
the US, this range is not the same for all firms. Typically, private firms are faced with a
narrower range of choices compared to publicly traded firms.
As the evidence points out, firms prefer internal to external financing. The main
reasons are that external financing, besides being costly, primarily for private firms, it
also implies a loss of control over the everyday running of the business as well as a loss
of financial flexibility. For example, a venture capitalist that invests in a firm will
demand participation in the decision making process and a firm that finances its
investments with debt will be more restricted as to how to allocate the cash flows
generated by these projects. Financing investments only through internal funds implies
that firms are restricted to pursue those projects that can be financed internally and
bypass other projects with positive NPVs that require larger financing. These projects
may, however, be successfully pursued by competitors with negative implications for the
future of the firm.

Firms can raise capital either from private sources or from going public. The
choice of financing source depends on a firms position in its life cycle. Young firms
depend more heavily on private sources given that they have unstable cash flows and are
faced with greater risk. As a firm grows and matures, its portion of financing from public
sources increases. Private sources include venture capitalists and private equity investors.
New businesses that are in need of additional financing on top of what the owners can
provide may approach a venture capitalist. Venture capitalists can either provide seed
money, meaning financing to new firms that want to test an idea or develop a product, or
start-up capital, meaning financing to develop and market established ideas or products.
Owners or start-up firms must sell their ideas or products to private equity investors in
order to convince them to provide financing. They must also negotiate with them a
number of issues, such as the firms valuation, the structure of the deal, the private
investors role in management, and the plan for taking the firm public in the future.
Private firms that have experienced growth and have established a position in
their market will then consider making the transition to a public firm through an IPO. As
a firm grows, it will find itself restricted in terms of financing choices. Moreover, making
the transition to a public firm is beneficial both to the firm and its owners. The firm now
has access to a larger supply of capital, while the firms owners will benefit by obtaining
a market value for their share of ownership. In many IPOs, the owners and private
investors will receive a substantial return on their investment. At the same time, the
private owners will face the costs that come with the loss of control. Moreover, public
companies are subject to more disclosure requirements, and information on the financial
health and business strategy of the company will be publicly available. Thus, it will be
more difficult for a firm to hide information from both its competitors and investors.
The IPO Process
Three factors affect a firms decision to make the transition from privately owned
to a publicly traded company: the firms size, its growth prospects, and the stage in its life
cycle. As firms grow and their future growth prospects and cash flows are more stable
and predictable, they can more easily access the capital markets through an IPO. Also,
younger firms with better future growth prospects decide to proceed with an IPO as
opposed to mature firms that prefer to raise capital by issuing long-term debt.
The case of Donaldson, Lufkin and Jenrette (DLJ) describes in detail numerous
issues surrounding the IPO process. It is important to emphasize the potential conflicts of
interest among the various participants in the IPO process as well as the risks that each of
them faces. The main participants are the issuing company (the company that goes
public), the underwriters, and the marketer. In addition, there is the regulator (SEC), but
we will not discuss its role here since this is done in the DLJ case.
The issuer would like to raise as much capital as possible at the lowest cost to the
current owners and thus would benefit by selling the shares at a higher price. In this case,
the issuer will raise more cash, will have a higher valuation, and there will be less
dilution of control for the existing owners. The issuer must weigh the benefits of a high

IPO price against the potential cost of a cold reception by investors. A lower price will
not only allow the shares to be sold, but will also improve the likelihood of a future IPO
and/or an issuance of debt. As the DLJ case also showed, a lower price may also benefit
current employees who may be given stock options.
The underwriter (typically an investment bank) plays the role of the intermediary
between the issuer and the investors who would buy the new shares. The underwriter will
purchase the shares from the issuer and then sell them to the investors or keep them in its
portfolio. Thus, the underwriter, besides providing valuable advice and expertise
throughout the IPO process, also absorbs the risk of selling the new shares by purchasing
them from the issuer and selling them to the public. This, of course, is facilitated through
the underwriters credibility and reputation with the investing public, which the company
that goes through an IPO lacks.
Given its intermediary role, the underwriter is faced with the difficult task of
pleasing both the issuer and investors. Therefore, an important part of the IPO process is
that the underwriter collects and processes information about the issuer and values the
issuers shares. The underwriter also uses marketers, which are companies that facilitate
the marketing of the issuers securities through brokers and sales people. In addition, the
underwriter and the issuers owners attempt to raise interest in the issue through road
shows. The pricing of the IPO is also facilitated through polling investors to gauge
demand at various prices.
Valuing the Firm and its Stock
An important part of the IPO process is the estimation of the value of the firm.
This, together with the size of the IPO, will determine the value per share for the firm.
After the intrinsic value per share is estimated, the issuer and the underwriter will agree
on the offering price per share. In most cases, the price will be set below its value so that
there is a higher likelihood of successfully selling the shares. Investors prefer to purchase
shares in an IPO under the anticipation that there will be a considerable capital gain in the
aftermath.
A standard approach to firm valuation is the DCF valuation. In this approach, we
discount expected free cash flows at a rate that reflects the firms risk (typically the
firms cost of capital). This approach is tedious and numerous issues must be addressed
throughout the process. These include the estimation of expected free cash flows, the
estimation of the tax rate to be used, the estimation of the firms future reinvestment
needs, the estimation of the discount rate, the consideration of the value of cash and nonoperating assets (such as marketable securities the firm may own), the impact of
warrants, management options and convertible bonds on firm value, and the impact of the
IPO on the control of the current owners.
In firms like DLJ, it may simply be very difficult to obtain good estimates of
expected cash flows due to the fact that these are affected by several factors that are
beyond the control of the company (such as the economic cycle, interest rates, etc.). In

general, though, how can we estimate the free cash flows to the firm? We can think of the
free cash flows as including the sum of the cash flows to the firms shareholders and
bondholders. One approach is to use the firms after-tax earnings after having subtracted
reinvestment expenses. For example, the free cash flow to the firm can be given by:
FCFF = EBIT (1-tax rate) (capital spending depreciation) change in
noncash working capital
Accounting for the firms reinvestment needs is important because these
investments will impact the firms current and future growth and, thus, its operating cash
flows. In any case, after we have derived the value of the firm through the DCF approach,
we can obtain the value of the firms shares by discounting the expected cash flows to
shareholders
FCFE = FCFF debt payments + new debt issued
Note that in addition to subtracting the cash flows to creditors from the free cash
flows to the firm we must also add any cash inflows from new debt that the firm issues.
These are also part of the cash flows to shareholders. Another way of estimating the value
of the firms shares is by using the dividend discount model.
As we also saw in a few cases, if we have forecasts of free cash flows for a future
period of, lets say, four to five years, we can use them to perform a DCF valuation. In
this case, we would discount these cash flows at the firms cost of capital and add to them
the firms terminal value. This value is calculated by assuming that free cash flows
beyond our forecasting horizon will continue to grow at a constant rate. This rate (g)
could be equal to the rate of sales growth that was assumed in the forecasting. Note,
though, that the sales growth rate cannot realistically exceed the nominal rate of growth
of the economy (GDP) in the long run. In the US, this has been around 6%. If there is
information about both the sales growth rate during the forecast period and the growth
rate of nominal GDP, then we must compare the two to ensure that we do not use a rate
(g) higher than the nominal GDP rate.1 Thus, we can use a constant-growth-valuation
model and calculate the terminal value as follows:
TV = (FCFF(1+g))/(WACC-g)
More typically, investment banks may obtain an estimate of a firms value and the
value of its shares though a relative valuation approach. In this approach a firms value or
the value of its shares is obtained by looking at how similar companies and their shares
are currently valued in the market. This approach uses various multiples, such as earnings
multiples, book value multiples, and revenue multiples. For example, commonly used
ratios are:

price/earnings per share ratio

Note also that the growth rate of nominal GDP is equal to the growth rate of real GDP plus the inflation
rate.

price/book value (of equity) ratio

the price/sales ratio.

The process involves two steps. First, we must define a group of peer companies
that are publicly traded. These companies must share a number of features with the issuer
such as cash flows, growth potential and risk profile. Second, a number of multiples, such
as price-earnings ratio, price-book value ratio, are obtained for each of the firms in the
peer group. We then calculate averages for the group and also consider the highest and
lowest values for sensitivity analysis. Using these multiples and accounting information
from the issuer, we obtain market values for the issuing firm and its shares.
This analysis must be conducted with caution. It is important to ensure that we
have a representative sample of peer companies. In some cases, this may be difficult to
achieve, such as in the case of industries that have a small number of firms. It is also
important to understand the drivers of these multiples. For example, the price-earnings
ratio depends on the growth, the payout policy, and the risk profile of a firm, while the
price-book value ratio depends on these three and the return on equity. These drivers help
explain differences in multiples between firms in the same industry.