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Comparable firm’s P/E multiple and IPO valuation: an empirical investigation for Indian IPOs

Abstract

We examine the influence of the comparable P/E (selected on different parameters, i.e., industry, revenue characteristics, book value, and return on net worth) on IPO pricing. The sample comprises of 120 IPOs issued in India during the period 2002–2007. We find that the comparable P/E chosen on the basis of industry alone shows poor estimation power. However, significant improvement in the estimation power of the comparable P/E approach is observed while tapering down the list of comparable firms from the identical industry (affiliating IPO firm) on the basis of revenue characteristics, book value, and return on net worth. We suggest that comparable firms selected from identical industry further adjusted with revenue characteristics and return on net worth provide the most efficient P/E multiple for evaluating IPO price. This paper also finds that IPO price estimated by multiplying current EPS of the IPO firm with benchmark peer group average P/E is positively associated with both offer price and list price, suggesting that higher value can be expected for IPOs relating to high-valued peer group and vice versa. Valuations tend to be more accurate (adjusted R 2 = 77.5 %), when the price is estimated on the basis of comparable peer group P/E along with a set of financial information. The offer price and list price are found positively and significantly influenced by the financial information, i.e., book value, growth and risk along with peer group P/E.

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Notes

  1. Valuation techniques used to evaluate equity stocks include dividend discount model (DDM), discounted cash flow model (DCF), residual income valuation model (RIV), price to book value, price to sales, price to cash flow, enterprise value to EBITDA, and enterprise value to sales.

  2. The companies specified in the peer group operate in the same industry and are engaged in similar line of business. P/E ratios for already listed companies in the peer group are published in Red Herring Prospectus (RHP) under the clause titled as “Basis For Offer Price.”

  3. Revenue characteristics indicate the firms operated in the same industries that have derived their sales revenue from similar kind of activities.

  4. P/E ratio is the most popular ratio being used by the investors while evaluating equity stocks (Roosenboom 2007). Regular discussions in the popular press also establish higher emphasis on P/E multiple while evaluating the value of the stocks.

  5. Capitaline database from capital market publishers provides data on share price, ownership, financials, and non-financials of companies including IPOs in India. Capital market is widely quoted in research reports, Red Herring Prospectus, and other valuation reports.

  6. Taking the advantage of bullishness in the secondary market, the IPO firms successfully sell the shares at a higher premium than the book value, because investors are overoptimistic about the growth prospects of the firm.

  7. Each IPO firm in India is required to insert one clause pertaining to “Basis for Issue Price” in the prospectus, which contains financial information (historical), i.e., earnings per share, return on net worth, and book value per share, for last three preceding financial years. In addition to that, a peer group comparative statement is also provided to justify the valuation for the IPO.

  8. Dielman (2007) suggested that multicollinearity may be a serious problem if any of the pairwise correlations among the X variables are larger than the largest of the correlations between the Y variables and the X variables.

  9. Kim and Ritter (1999) document R 2 = 5.0 %, while Chang and tang (2007) find R 2 = 2.18 % while evaluating the P/E of the IPO firm by using median P/E of the comparable firms.

  10. Clean surplus-based valuation framework is suggested by Ohlson (1995).

  11. Observed positive association between issue price and risk (measure by leverage) is, however, inconsistent with Cotter et al. (2005).

  12. Correlation matrix for debt, age, offer size, and total assets is not shown in the text.

  13. Existing studies (Beatty and Ritter, 1986; Carter et al., 1998; Yu and Tse, 2006) suggest an inverse of size as proxy for the risk of the firm.

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Correspondence to Seshadev Sahoo.

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Sahoo, S., Rajib, P. Comparable firm’s P/E multiple and IPO valuation: an empirical investigation for Indian IPOs. Decision 40, 27–46 (2013). https://doi.org/10.1007/s40622-013-0008-y

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Keywords

  • IPO
  • Peer group
  • P/E
  • Growth
  • Book value
  • Risk
  • Comparable firm