How Do Investment Banks Price Initial Public Offerings? An Empirical Analysis of Emerging Market

Abstract

This study investigates that how investment banks select alternative valuation models to price Initial Public Offerings (IPOs) and examine the value-relevance of each valuation model using the data of 88 IPOs listed on the Pakistan Stock Exchange (PSX) during 2000–2016. This study investigates that investment banks used Dividend Discount Model (DDM), Discounted Cash Flow (DCF) and comparable multiples valuation models on the basis of firm-specific characteristics, aggregate stock market returns and volatility before the IPOs. In this study, a binary logit regression model is used to estimate the cross-sectional determinants of the choice of valuation models by investment banks. The results reveal that underwriters are more likely to use DDM to value firms that have dividends payout trail. The investment banks select DCF when valuing the younger firms, that have more assets-in-tangible, firms that have negative sales growth and positive market returns before the IPO; while comparable multiples are used for mature firms and firms that have less assets-in-tangible. Furthermore, this study also used OLS regressions to examine the value-relevance of each valuation model and Wald-test to examine the predictive power of cross-sectional variation in the market values. The findings unveil that P/B ratio has highest but DCF has lowest predictive power to market values. The Wald-test results depict that none of the valuation methods produces an unbiased estimate of market values.

Valuing local and dual-class IPOs in the Alternative Investment Market

“…That comparable firm has designated a benchmark for determining the IPO offering price (Kim & Ritter, 1999). This method takes into account the relative value of assets of a competitive firm and then prices the shares of the IPO company based on this relative value using various financial indicators (Agnes Cheng & McNamara, 2000;Rasheed, Khalid Sohail, Din, & Ijaz, 2018).…”

“…The most popular method used in the comparable firm approach for the valuation of IPOs is the dividend discount model. That model is based on the proposition that the value of a firm's stock is equal to the discounted value of the infinite cash flow of the expected dividends per share (Rasheed, Khalid Sohail, Din, & Ijaz, 2018;(Gacus & Hinlo, 2018;Sim & Wright, 2017). The other approach firm analysis for the IPO valuation is the discounted cash flow method.…”

How discounts impact IPOs valuation performance and underpricing? A confrontation between warranted and unwarranted discounts

“…They explain that underwriters deliberately overestimate IPOs to justify applying high levels of discounts. Rasheed et al (2018), Roosenboom (2012) and Tutuncu (2020) find that discounts depend on valuation optimism. Additionally, Cassia et al (2004), Paleari et al (2014) and Vismara et al (2015) find that underwriters perform a biased selection of peers to overestimate IPOs.…”

“…Actually, only a limited number of studies examining IPOs discounts can be found due to the public unavailability of such information. Most of these studies report that discounts are applied to FVE before setting FOP (Cassia et al, 2004;Deloof et al, 2009;Paleari et al, 2014;Rasheed et al, 2018;Roosenboom, 2012;Tutuncu, 2020;Vismara et al, 2015). They explain that underwriters deliberately overestimate IPOs to justify applying high levels of discounts.…”

“…However, while underpricing and initial returns are identical because they both refer to the difference between MP and FOP, the same cannot be said about a discount. Actually, considering discount the same as underpricing and initial returns can be misleading because it does not represent the real discount applied by underwriters when valuing IPOs (Cassia et al, 2004;Deloof et al, 2009;Paleari et al, 2014;Rasheed et al, 2018;Roosenboom, 2012;Tutuncu, 2020;Vismara et al, 2015). This real discount refers rather to the difference between FOP and fair value estimate (FVE) for fixedprice offerings and preliminary offer price (POP) for book-building offerings (Roosenboom, 2012).…”