Pricing Dynamics

IPO basics first! The initial public offering (IPO) signifies the public debut of a private company's stock. IPO valuation in the market facilitates the acquisition of equity capital by businesses from public investors and offers an exit strategy for early private investors. Capitalizing on IPOs can yield significant returns for investors.

A significant factor in determining the fate of an IPO investment is the pricing. The ultimate IPO price is determined following an evaluation of investor demand during the book-building phase. Prioritizing long-term returns over short-term listing premiums,  investors must evaluate the IPO price in light of the company's valuation and fundamentals. 

On average, IPOs are underpriced by around 10 to 20% on the first day of trading. This means the offer price is often lower than what the market determines as the true valuation  once trading begins. However, not all IPOs enjoy a strong first-day pop. Savvy investors should still assess the issuer's financial health and growth prospects before participating. 

 

Process of Determining IPO Prices

• Assessing Company Valuation: By analyzing IPO valuations of similar public companies through the application of trading multiples such as P/E and P/S ratios, investment banks approximate the valuation that investors may attribute to the IPO company.
• Gauge Investor Demand: The underwriting banks assess the level of demand for the company's shares for effective IPO valuation in the market by marketing the IPO to institutional investors.
• Setting the Price Range: In the IPO submission documents, the banks and issuer establish an initial expected price range in consideration of investor demand and valuation analysis.
• Running Order Book Process: Institutional investors indicate the quantity of a given offering price at which they are willing to purchase by placing orders, which further refines pricing.
• Final Pricing: The ultimate IPO price is determined by investor sentiment and is either at the midpoint or the upper end of the predetermined range. Fluctuations of up to 20% from the midpoint are typical.

 

Key Factors Influencing Price Decisions

• Current Market Conditions: Prices tend to be higher when overall markets are bullish and IPO investor sentiment runs high.
• Financial Performance and Growth: Valuation is directly influenced by profitability, revenue growth, addressable market size, and additional financial metrics.
• Quality of Underwriters: Prestigious underwriter banks instill greater assurance regarding the pricing of offerings.

 

Cut-Off Price Significance

The cut-off price in IPOs is the offer price at which shares are issued to investors within the specified price band. Investors submit proposals to businesses that specify the number of shares sought at or above the specified price range. The cut-off price is determined after assessing investor demand during the book-building procedure. It is the price at which all allotments are made, and the issue is oversubscribed. 

Increased demand for the stock enables the business to establish a higher cut-off price. Applying at a price level that is equivalent to or higher than the cut-off price improves the likelihood of allotment for investors. 

Investors whose bids fall below the set level risk being rejected. It also provides an early indication of the stock's potential listing. In general, an exceedingly high cut-off value results in an increase in listing value. For example, the IPO of Apollo Micro Systems Limited was oversubscribed by 248.51x. In general, an exceedingly high cut-off value results in an increase in listing value. Therefore, investors must comprehend the dynamics of the cut-off price to increase their chances of securing allotments in an IPO. 

 

Investor Participation Impact

Both institutional and retail investors participate in IPOs. Retail consists of individual vendors with a minimum investment of one lot. Institutional funds are sizable foreign or domestic funds. Not more than 50% of the issue size is reserved for qualified institutional purchasers, and not less than 35% is allocated to retail investors by SEBI regulations.(Issuers may decide to raise the IPO price in response to a high IPO's GMP)

The extent of involvement from these categories is crucial in establishing the minimum price and allocation. Due to the substantial demand from institutional investors, the firm can command a premium price. Retail demand is frequently motivated by listing gains, whereas institutional demand is motivated by extensive research and risk tolerance necessary to evaluate the company's potential.

A concentration of retail bids near the upper limit of the price band indicates significant confidence. This also stimulates institutional bids at an increased price. The stock will likely receive a higher cut-off price and substantial listing gains as a result. Gaining insight into bid patterns enables investors to evaluate demand and detect opportunities with greater likelihoods of being allocated and generating returns.

 

Risk Awareness and Tips

Investors must understand the various Risk Factors in IPO that need to be evaluated before applying for shares in a public issue. Some of the key risks and tips for investors to be aware of include:

• Not all companies that list via IPOs achieve the anticipated level of performance after the offering. Conduct an exhaustive analysis of the organization's finances, industry, and management history.
• Newly incorporated businesses may lack the necessary track record to justify making predictions. This is why you must invest in established enterprises.
• IPOs are frequently oversubscribed due to hype. Be aware of listing gains unless you have a solid grasp of long-term business and valuation.
• Invest in a diversified portfolio of IPOs to reduce company-specific risks.
• Apply near the upper limit of the price range only if you are certain of the prospects at that price.
• Do not invest more than 5% of your total capital in a single IPO to prevent portfolio volatility.
• Establish price objectives and record a portion of the profits if the stock rapidly attains the target price subsequent to its listing. Permit victors to perform for an extended period.

Final Takeaways

Given the current bull market in domestic stocks, 2024 is expected to see a major increase in new-age tech IPOs as well as SMEs. Decoding IPO price cut-offs and understanding the basics of the IPO process are crucial for investors to maximize their chances of successful allotment and returns. If you are still wondering how to apply for IPO at cut-off price, open your demat account with Almondz and simplify the entire process. With its dedicated RM support, you can participate in IPOs to build a profitable portfolio.

Disclaimer: This blog is posted solely for educational purposes. The securities mentioned are examples and not recommendations. It is based on various secondary sources from the internet and is subject to change. Kindly consult an expert before making any related decisions.