BFF3351: Week 2 Lecture NOTES
Public Offerings – Part I
Initial Public Offerings
- Occurs when securities are sold the public for the first time, they are listed on an
exchange with the expectation that the liquid market will develop.
- Advantages of going public
o Exit strategy for founders
o Better access to capital markets and increased liquidity
o Enhances firm’s external credibility
o Company’s value is function of security price in the market
o Potentially more funding to expand and grow
o Allows debts/ loans to be paid off
- Key disadvantages
o Increased disclosure and cost
o More shareholders to manage – potentially short-term focus
o Original shareholders become diluted (may become minority holders)
Costs of IPOs
- The cost of an IPO is substantial
- Substantial one-time costs include
o Direct: underwriting, legal, printing, auditing
o Indirect: under-pricing (shares sold at offer price – money left on the table)
- Studies show
o Direct costs = ~7% of gross proceeds
o Indirect costs = varying % (large for small issues)
Valuing IPOs
- Need to comply with S 718 of Corporation’s Act
o Registration/ lodgement of prospectus
- An IPO can be underwritten (not required)
- Discounted cash flows (DCF) and relative valuation analysis are common techniques
used
- Offer price (fixed-price offer, auction or bookbuilding)
- Final valuation dependent on form of issue
Reasons for under-pricing of IPOs
- To entice investors to subscribe for risky issues
o A trade-off of lower price for a certainty of receiving funds
o The greater the uncertainty the lower the price
o Avoid under-subscription (underwriter would need to take up these shares) or
failed offer if subscription level below minimum agreed in prospectus.
- Information asymmetry
o Informed investors: due to additional information will only apply when IPO is
under-priced
o Uninformed investors: get all shares they demand (the lemon problem)
o If new shares are not under-priced, uniformed investors will, on average,
systematically lose money
- Bandwagon Cascade Hypothesis:
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o A potential investor pays attention not only to information but to whether
other investors are purchasing
o Under-pricing induces first potential investors to buy
Lawsuit Avoidance Hypothesis:
o Due possibility of investor lawsuits for losses sustained, under-pricing may
reduce frequency and severity of lawsuits
Signalling
o Under-pricing leaves good taste with investors, allowing sale of future
offerings at higher price than otherwise
Regulatory Constraints
o On privatisation, gives investors a good taste of capitalism
Underwriter reputation
o Higher reputation/ lower underwriting
o Likely parallel direction in fees
o Underwriters can reward favoured clients by allocating shares in IPOs likely
to be under-priced
Going Public Process
- Underwriting
o May have dual role of underwriter/ marketer
 Underwriting means absorbing/ buying/ retaining any shortfall shares
in the offer
o Role of sub underwriters
o Existence of underwriting agreements
 Use of out clauses under specific agreements
- Risks of underwriting
o Issue size in terms of underwriter’s balance sheet
o Length of time-table for which underwriters are a risk
Bookbuilding
- A US developed concept
o Greater flexibility in promotion prior to registration of prospectus
o Retail investor interest can be recorded/ calculated
o Price set after. Road show and building book of interest
o May only be underwritten as to settlement risk
o Seeks to match supply and demand
- Minimises time between pricing of issue and trading in secondary markets
- Bookbuilding via a “road show”
Tender Offers
- Tender offers are made above minimum price
- If offer is oversubscribed, priority is given to highest tenderer
- Two techniques used:
o Common strike price method
o Pure tender method
- Pure tenderer:
o Highest bid wins
o Not used now
- Common strike method
o Investors submit competitive bids for specific amounts of shares at various
prices
o Common strike price is determined for all investors, based on which there is
most demand
o Encourages higher bids to secure share allocation. If shares are tendered at too
high a price, bidders receive shares at same price as other investors
Open Price Bookbuilding
- Followed in US: final price set at end of offering period
- Use of the indicative price range delivers more accurate pricing level
- Provides guide as to value of shares
- Prices set by lead managers and issuing firms
o Lower end at sufficiently attractive level to firm
o Higher end at price which exceeds issuing firm’s price objective, but is
realistic
o Range about 10%
- If strong demand indicated, final price can be at or above upper limit
- If demand is low, offer can be withdrawn, or price range reduced
Constrained open pricing
- A dual pricing basis
- Retail investors apply at capped price
- Institutional and foreign investors pay strike price (after bookbuilding)
- E.g., Medibank
Green Shoe
Public Offerings
Relative valuation/ Market Comparable
- Technique used to value businesses, business units and other major investments
o Assumes similar assets should sell at similar prices
o The critical assumption underlying the approach is that the “comparable”
assets/ transactions are truly comparable to the investment being evaluated
- Relative valuation should be used to compliment DCF analysis
- Steps in relative valuation
o Step 1: Identify similar or comparable investments and recent market prices
for each
o Step 2: Calculate a valuation metric for the asset
o Step 3: Calculate an initial value of the asset
o Step 4: Refine the valuation to the specific characteristics of the asset
Equity Valuation using price to earnings (P/E) ratio
- Analysts usually focus on predicting the earnings of firms they evaluate and then use
the P/E ratio to evaluate the price of common stocks
- Earning power is a chief driver of investment value, EPS (the denominator for P/E) is
the chief focus of most security analysts
- The P/E ratio is widely considered as the most familiar valuation method
o Estimated value of firm equity = (price per share of comparable firm / Earning
per share of comparable firm) x earning per share of firm being valued
Trailing or Leading
- The current price can be observed, as can earnings
o However, earnings can be reported earnings (trailing) or forecast earnings
(leading)
- The trailing ratio uses reported earnings (historical earnings) and will generate a
different result to the leading ratio if companies have growth
- It is important to apply a trailing P/E ratio to reported earnings and a leading P/E ratio
to forecast earnings when estimating price
- Trailing P/E ratio: P0/E0
- Leading P/E ratio: P0/E1
Leading P/E ratio = (payout ratio) / (r – g)