How to Determine a Pre-IPO Stock Price

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IPOs often jump sharply in their first day of trading.
IPOs often jump sharply in their first day of trading. (Image: Zedcor Wholly Owned/PhotoObjects.net/Getty Images)

Private companies go public through initial public offerings. They engage investment bankers to manage the IPO process. This includes filing registration documents with the U.S. Securities and Exchange Commission, determining the pre-IPO offering price, deciding the IPO size in terms of the number of shares, and marketing and creating demand for the shares among potential investors. Compute the market value as a first step in determining the pre-IPO stock price.

Provide the necessary financial information to the lead investment bank. This includes historical operating results, realistic projections, business conditions, key customer segments, risk factors and product development pipeline.

Estimate the value of your company. You could use discounted cash flow modeling to compute the present value of future net income using a discount rate. Net income is sales minus operating and non-operating expenses. The discount rate could be a combination of the risk-free rate, which is usually the three-month Treasury bill rate, plus a risk premium.

A simpler and more common option, according to information on New York University professor Aswath Damodaran's website, is to use multiples, such as the price-to-earnings ratio, or P/E ratio, for comparable firms. The P/E ratio is equal to the market price divided by the earnings -- net income minus preferred dividends -- per share. For example, if a comparable firm in your industry has a P/E ratio of 20 and your average annual net income is $500,000, the value of your company is about $10 million, where $500,000 times 20 equals $10 million.

Establish the IPO size. Several factors come into play, according to "Inc." magazine, such as demand and the issuing company’s funding requirements. For example, increase the IPO size if demand is high, which keeps the price affordable to more investors while raising additional funds. Your specific requirements for the funds could play a role -- for example, if your needs are modest, go with a smaller IPO.

Calculate the value per share, which is the value of the company divided by the number of shares. Continuing with the example and assuming an IPO size of 1 million shares representing 100 percent of the company, the value per share is $10, or $10 million divided by 1 million.

Determine the offering price per share, which might be lower or higher than the value per share. According to "Inc." magazine, investment banks target an offering price around $15 to make the shares attractive to more investors. The share price affects perception. If you set the price too low, investors might think that there is something wrong with the business fundamentals. On the other hand, if you set it too high, you might not attract enough investor interest.

Tips & Warnings

  • Valuation is difficult for rapidly growing companies, because historical results might not reliably predict future performance.

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