How IPO Prices Are Really Decided [Book Building Process]

IPO Book Building Tool

Introduction

You've heard about Initial Public Offerings (IPOs), right1? It's always exciting when a new company decides to go public, selling its shares to us, the general public, for the very first time. Why IPO is exciting? Because it gives us the change to invest and participate in their growth story.

But have you ever wondered how do they decide the price of these IPO shares?

How do they know what's fair?

Well, for sure it’s not just a random number. Figuring out that IPO price is actually a rather complex process.

Today in this post, we'll talk about the most common and efficient way this happens in India. This method is called the book-building process.

1. What is Book Building?

When a company decides to go public and offer its shares to everyday investors for the very first time (IPO) they use this process. Book building is basically the clever method they use to figure out the perfect starting price for those shares

Unlike a fixed-price IPO where the price is set in advance, the book-building method doesn't fix the price upfront. Instead, it's a price discovery mechanism. Read more about price discovery of stocks here.

Here's how it generally works:

• The company announces a price range for its shares, often called the price band.
• This band has a lower limit, known as the floor price, and an upper limit, called the cap price.
• Investors like us are then invited to submit bids within this specified range.
• After the bidding period ends, the final price, which is known as the cut-off price, is determined based on the actual demand from potential investors.

1.1 How the lower & upper limits of the IPO share price is determined?

The company planning the IPO, in close consultation with its lead managers (also known as merchant bankers, book runners or underwriter), determines the price band.

This isn't an arbitrary decision but a well-researched process that involves several factors:

1. Company Valuation: They meticulously analyze the company's past and present financial health. They look at metrics like revenues, profits, assets, liabilities, and cash flow. They also look at the sustainability of the business model, its competitive advantages, and future growth potential are key considerations. They also assess the industry in which the company operates, looking at industry trends, market size, and growth rates.
2. Peer Comparison (Comparables Analysis): They look at the valuations and IPO prices of similar companies that are already listed on the stock exchange. This helps in benchmarking and determining a fair range. They consider metrics like P/E, EV/EBITDA, P/B ratios etc, of comparable companies.
3. Market Conditions and Investor Sentiment: The overall health of the stock market, prevailing economic conditions, and general investor sentiment towards IPOs also play a significant role. If the market is bullish, they might set a slightly higher price band, and vice-versa. They also gauge initial interest from potential investors (especially Qualified Institutional Buyers - QIBs) through pre-IPO discussions and roadshows.
4. Issue Size and Capital Needs: The amount of capital the company aims to raise from the IPO also influences the price band. The total issue size divided by the number of shares offered will give a rough idea of the per-share value.
5. Regulatory Guidelines (e.g., SEBI in India): Regulatory bodies like SEBI in India have specific guidelines for the price band. For instance, the cap price (upper limit) typically cannot exceed 20% of the floor price (lower limit).

2. Why Companies Prefer This Method

You might be asking, why go through all this trouble when they could just set a fixed price?

That’s a fair question.

The answer lies in the several benefits that book building offers.

• Efficient Price Discovery: Book building is seen as a highly efficient way to determine the price of securities. It's truly a market-driven process. The price is determined by investor interest and market conditions, rather than being an arbitrary decision made solely by the company.
• Accuracy and Realistic Pricing: This method helps the company arrive at a price that is likely to be closer to its real intrinsic value. This also helps in minimizing the risks of overpricing or underpricing that can sometimes lead to poor performance after the IPO is listed.
• Transparency and Investor Confidence: The book-building process promotes transparency by publicly disseminating bidding information. Knowing that the price is determined by market demand, and not just by the company, generally enhances investor confidence. This in turn encourages greater participation from all types of investors.
• Cost Savings: While it involves underwriters, book building can actually save funds that would otherwise be spent on extensive marketing and advertising. This is what's expected to happen in a fixed-price IPO.

3. Difference Between Fixed Price IPO and Book Building IPO

Both are distinct methods companies use to determine the price of their shares when they go public for the very first time (an IPO).

Here's a comparison that will show you the difference between the two methods:

Description	Fixed Price IPO	Book Building IPO
Price Setting	Price of shares is fixed and announced upfront before bidding starts.	Price of shares is discovered during the bidding process, within a pre-announced price range.
Price Discovery	No price discovery mechanism. Investors simply buy at the fixed price.	A core mechanism for discovering the right price based on investor demand.
Price Band	Not applicable. There's only one set price.	A "price band" (lower limit: Floor Price, upper limit: Cap Price) is announced. Investors bid within this range.
Bidding	Investors apply for shares at the single, fixed price.	Investors place bids for shares at different prices within the announced price band.
Demand Visibility	The company and lead managers don't know the exact demand until applications are closed.	Real-time visibility of demand at various price points, helping determine the final price.
Flexibility	Less flexible; if the market sentiment changes, the fixed price might not be optimal.	More flexible; the final price adjusts to market demand, reducing the risk of undersubscription or overpricing.
Who Benefits	Can be simpler for retail investors due to the clear price.	Benefits the company by getting a fair market price and institutional investors by allowing price flexibility.
Typical Use For	Often used by smaller companies or when market conditions are very stable and predictable.	Widely used by larger companies, especially in dynamic markets, to ensure optimal pricing and subscription.
Application Type	Investors simply state the number of shares they want to buy.	Investors state both the number of shares and the price at which they are willing to buy (within the band).
Final Price	The same fixed price for all successful applicants.	A "cut-off price" is determined based on demand; all successful applicants get shares at this price.

4. The Journey of an IPO Through Book Building

So, how does this sophisticated price discovery happen in practice?

Let’s analyze it through the steps:

1. Hiring the Experts: It all begins with the issuing company. They appoint an investment bank to serve as an underwriter or lead manager. These financial experts are tasked with assessing the company's value, determining the issue size, and setting the initial price range for the shares. SEBI's guidelines often mandate that the difference between the lower (floor) and upper (cap) price of this band should not exceed 20%.
2. Inviting Bids: Once the price range is set, the underwriter prepares a prospectus and sends it out to the investment community. They invite institutional investors, mutual fund managers, to submit their bids. These bids specify the number of shares the investor wishes to purchase and the price they are willing to pay within the given band.
3. The Bidding Period: The IPO remains open for a specific period, typically 3 to 7 business days. During this time, all investor bids are recorded in an "order book" maintained by the underwriter. The demand for the IPO can be tracked daily as this 'book' builds. If the price range needs to be revised during this period, the offering period might be extended by three days.
4. Determining the Final Price: After the bidding window closes, the investment bank meticulously evaluates the combined demand from all the received bids. They then use a weighted average method to calculate and arrive at the final issue price. It is also known as the cut-off price. This is the price at which the shares will ultimately be issued to successful bidders.
5. Transparency and Allotment: For transparency, the underwriter is required to publicize all the details of the submitted bids. Then comes the allocation phase. Investors who submitted their bids at a price equal to or higher than the determined cut-off price are considered for share allotment. If you bid below the cut-off price, your bid will be rejected. In this case, any blocked application money will be refunded in full. Sometimes, if the demand for the issue is overwhelmingly high, the maximum price (cap price) in the band often becomes the cut-off price.

It's also worth noting that SEBI guidelines allow for flexibility in the offering structure.

A company can opt for a 100% book-built offer, where the entire issue's pricing is determined this way, or a 75% book-built offer, where 75% goes through book building. The remaining 25% is offered at a fixed price derived from the book-building process.

5. Associated Risks and Why IPOs are Underpriced Sometimes

While book building is efficient, it's not entirely without its risks.

• One risk is the possibility of overvaluing the securities. If shares are priced too high, it might discourage potential investors, leading to a price drop after listing. PayTM stock had a disastrous debut. It listed at around Rs.1560 per share. In the next six months it fell to Rs.545 levels. Similarly Zomato (Eternal)
• There's also a chance that potential investors might not be completely transparent about their true interest which can distort the accurate picture of demand. What does it mean? It means that potential investors (example mutual funds, insurance companies, HNIs, etc) might not be completely transparent about their true level of interest during the bidding phase. This lack of transparency can lead to an inaccurate picture of the actual demand for the securities. Consequently, this distorted view might cause the issuer to misjudge the market's true interest and potentially overvalue the securities. This will eventually lead to poor performance once the shares start trading on the secondary market.
• The process can sometimes be time-consuming and expensive. It might look like this especially for smaller companies or those with less established track records.

The market has also seen the issue of IPO underpricing.

This is when the initial offer price is set lower than what the market might be willing to pay.

Why does this happen? Well, it's often a strategic move to attract broader investor interest and ensure the IPO is oversubscribed. It helps create a positive market sentiment and encourages trading activity once the shares are listed.

A company might strategically underprice to mitigate initial risks and achieve good overall results, particularly if they are less known or less liquid.

Conclusion

Understanding the book-building process is really fundamental for anyone looking to participate in IPOs.

It’s a dynamic and comprehensive method that allows for fair price discovery driven by actual market demand. It will ensure a more precise valuation for new shares entering the stock market.

For companies, it’s about maximizing the capital they raise effectively.

And for investors like us, grasping these nuances helps us make more informed investment decisions.

So, the next time an IPO comes into the market you’ll know a lot more about how its price was determined (Book Building or Fixed Price method).

Have a Happy Investing.