Impact of Fundamentals on IPO Valuation

Rajesh Aggarwal Sanjai Bhagat Srinivasan Rangan

2009
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Motivation

The second half of the 1990s witnessed several significant innovations in technology and the rise of the internet sector. This has been labeled as the new economy period. In the new economy period (or boom period), equity values in the U.S., especially those of initial public offering (IPO) firms, reached unprecedented heights.
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Motivation

Early profitability is not the key to value in a company like this (Inktomi). Jerry Kennelly, Chief Financial Officer of Inktomi Inc (1999). But valuations are just as often based on gut feel. As one entrepreneur told me, Its as if everybody just settles on a number that they are comfortable with. Gove (2000) in Red Herring.
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Motivation

Were traditional value-relevant variables such as income, sales and book value of equity valued differently in the boom period relative to an earlier time period for IPO firms? Also, beginning from March 2000, the U.S. stock market took a dive (crash period). So the other question is How did these variables fare in the crash period?
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Discounted Cashflow Valuation

t = n CF t Value = t t =1 (1 + r)
where, n = Life of the asset CFt = Cashflow in period t r = Discount rate reflecting the riskiness of the estimated cashflows

Research Questions

Were the following variables valued differently by investment bankers and first-day investors in the boom and crash periods relative to the second half of the 1980s? Income Book value of equity Sales R&D Industry price-to-sales ratios Insider retention Investment banker prestige Were the valuation of these variables different for tech firms, internet firms, and loss firms?
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Priors / Expectations

Based on anecdotes, we expect that income would be valued less in the boom period relative to the 1980s. Based on anecdotes, we expect that sales would be valued more in the boom period relative to the 1980s. Given the above two priors, we expect insider retention and IB prestige to be valued more in the boom period relative to the 1980s. We had no priors on how things would change in the crash period, and so we let the data speak. For technology and internet firms, we expect income and sales to be less valuable and insider retention and IB prestige to be more valuable. For loss firms, we expect income to be valued less, and insider retention and IB prestige to be valued more.
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Model Specification
Dependent variable choices

Price-to-earnings ratios

Problem: Leads to elimination of IPOs with negative earnings from the sample. 63% of IPOs during 19972001 have negative earnings.

Price-to-sales ratios

Problem: Some IPOs during 1997-2001 have zero or extremely small values for sales.

Price per share

Problem: Investment bankers estimate total offer value first and then partition it somewhat arbitrarily into price per share and shares outstanding. Modal offer price in our sample of IPOs is $12: Pre-IPO income for these firms ranged from

-$66 million to $71 million.

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Model Specification
Dependent variable choices

Offer value in millions of dollars.

Problem: non-normality.

Logarithm of Offer value. Logarithm of first-day Market value.

Model Specification
Independent variables (expected signs)

Prior-Year Income (+) Prior-Year Book value of equity (+) Prior-Year Sales (+) Prior-Year R&D (+) Pre-IPO Industry median price-to-sales ratio (+) Post-IPO insider retention (+) Investment banker prestige (+)

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Model Specification

Boom Crash Loss Tech Internet

= 1 if the offer date is during 1/1997-3/2000, and 0 otherwise. = 1 if the offer date is during 4/2000-12/2001, and 0 otherwise. = 1 if income before extraordinary items is negative, and 0 otherwise. = 1 if a firm belongs a technology industry, and 0 otherwise. = 1 if a firm belongs to an internet industry, and 0 otherwise.

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Table 1 Summary statistics of 1,855 US IPOs during 1986-1990 and 1997-2001

Year

Numb er of IPOs

Offer value

Mark et Valu e

Sales

Inco me

Book value of equit y

R&D

Industr y Pricetosales multipl e

Insider retentio n

Investm ent banker prestige

Panel B: Medians 1986 1987 1988 1989 1990 1997 1998 1999 2000 2001 230 179 70 77 77 330 197 359 285 51 49.0 58.0 61.5 67.5 77.6 99.2 147.5 291.7 377.9 321.5 51.3 62.1 72.6 76.3 84.0 106.6 166.0 425.1 473.4 356.4 27.7 26.1 29.3 33.6 30.0 24.2 22.2 8.2 8.6 68.0 1.1 1.2 1.4 1.9 1.4 0.7 -0.1 -5.6 -8.9 -3.7 4.0 3.7 3.3 5.7 4.9 4.4 2.4 -0.2 -0.2 -2.2 0.0 0.0 0.0 0.0 0.2 0.0 0.0 1.6 3.7 0.0 2.5 2.7 1.7 2.7 3.0 3.2 3.9 31.7 39.2 3.0 0.70 0.72 0.75 0.72 0.71 0.70 0.73 0.81 0.82 0.76 8.1 8.8 8.8 8.8 8.8 8.1 8.1 9.1 9.1 9.1

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Panel C: Frequencies Year % of loss firms % of Technology IPOs 20.4 25.1 30.0 33.8 31.2 35.8 43.7 64.9 58.2 35.3 % of Internet IPOs

1986 1987 1988 1989 1990 1997 1998 1999 2000 2001

21.7 19.6 21.4 22.1 20.8 42.7 53.3 80.5 84.9 68.6

-----3.3 17.3 59.1 38.2 5.9

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Table 2 Relation between IPO values and time period dummies, accounting variables, growth proxies, investment banker prestige, and insider retention Sample of 1,655 US IPOs completed in 1986-1990 and 1997-2001.

Independent Variables

L(Offer Value)

L(Total Market Value)

L(Offer Value)

L(Total Market Value)

Intercept

4.18 (106.1) 1.03 (19.7) 1.70 (25.4) --

4.25 (106.8) 1.27 (21.9) 1.87 (24.4) --

-0.77 (-6.2) 0.79 (22.1) 0.95 (17.5) -0.07 (-5.7) 0.01 (1.4) 0.15 (10.4) 0.07 (3.1) 0.07 (5.5) 0.24 (23.9) 3.58 (19.3) 0.743

-1.31 (-8.6) 0.92 (22.7) 0.90 (13.7) -0.09 (-6.0) 0.01 (.9) 0.14 (8.3) 0.11 (3.8) 0.10 (6.4) 0.25 (21.0) 4.31 (19.3) 0.710

Boom

Crash

L(Income)

L(BV)

--

--

L(Sales)

--

--

L(R&D)

--

--

L(Price-to-sales Comparable) Investment banker prestige Insider Retention Adjusted R2

--

--

--

--

-0.267

-0.261

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Table 3, Appendix Table 1 Inter-temporal differences and inter-industry differences in IPO valuation of accounting variables, growth proxies, investment banker prestige, and insider retention Sample of 1,655 US IPOs completed in 1986-1990 and 1997-2001.
1980s Offer value Intercept 0.31 (1.5) 0.21 (5.2) 0.22 (8.3) -0.003 (-0.2) 0.13 (3.4) 0.07 (2.7) 0.15 (11.2) 2.12 (6.6) Market value 0.47 (2.0) 0.21 (4.6) 0.22 (7.5) -0.003 (-0.2) 0.11 (2.5) 0.07 (2.6) 0.13 (8.9) 2.17 (6.0) Boom period Offer value 0.32 (1.2) 0.07 (2.0) -0.13 (-3.9) -0.004 (-0.2) -0.15 (-3.4) 0.02 (0.6) 0.10 (6.4) -0.06 (-0.1) Market value -0.13 (-0.5) 0.06 (1.5) -0.12 (-3.5) -0.007 (-0.3) -0.14 (-2.8) 0.07 (1.7) 0.13 (7.4) 0.27 (0.6) Crash period Offer value 0.60 (1.3) 0.08 (2.0) -0.19 (-5.3) 0.05 (1.9) -0.06 (-1.1) -0.10 (-2.6) 0.18 (5.7) -0.51 (-0.9) Market value 0.57 (1.0) 0.08 (1.7) -0.20 (-4.7) 0.05 (1.9) -0.03 (-.3) -0.10 (-2.1) 0.23 (5.4) -0.96 (-1.4) Tech firms Offer value -0.86 (-3.8) 0.05 (2.3) -0.03 (-1.1) -0.02 (-1.3) -0.07 (-2.0) 0.01 (-0.6) 1.40 (4.1) 1.40 (4.1) Market value -1.07 (-3.7) 0.07 (2.7) -0.05 (-1.7) -0.02 (-1.2) -0.02 (-.4) 0.02 (0.7) -0.01 (-0.5) 1.71 (4.0) Internet firms Offer value -0.03 (-0.1) 0.02 (.9) -0.09 (-2.3) 0.03 (1.6) 0.07 (1.6) -0.06 (-2.2) -0.08 (-2.7) 1.50 (2.7) Market value -0.46 (-0.9) 0.05 (1.3) -0.08 (-2.0) 0.04 (1.9) 0.14 (2.2) -0.10 (-2.6) -0.09 (-2.2) 2.45 (3.3) Loss firms Offer value -0.10 (-0.4) -0.49 (-11.3) Market value -0.24 (-0.8) -0.48 (-9.1) -

L(Income)

L(Sales)

L(BV)

L(R&D)

L(Price-to-sales comparable) Investment banker prestige Insider retention

-0.003 (-0.2) 0.60 (1.6)

-0.001 (-0.01) 0.76 (1.7)

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Results

Controlling for IPO fundamentals and allowing for different valuation of these fundamentals across different time-periods,

Average

IPO valuations in the late 90s were not statistically different than those of the late 80s.

Nave interpretation of above result: IPO valuations in the late 90s were not excessive compared to the late 80s. We would caution against such an interpretation, since we find that fundamentals, especially income and sales, were valued quite differently in the late 90s.
Above results hold after controlling for endogeneity of insider retention and investment banker prestige. (Appendix Table 2) Above results hold in robust regressions. (Appendix Table 3)

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Results

Controlling for IPO fundamentals and allowing for different valuation of these fundamentals across different industries,

Tech

IPOs are valued less than non-tech IPOs.

Income and insider retention are valued more for tech firms.

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Results

Controlling for IPO fundamentals and allowing for different valuation of these fundamentals across different industries,

Internet

IPO valuations were not statistically different than noninternet IPOs.

For internet firms, insider retention is valued more, but investment banker prestige, surprisingly, is valued less.

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Results

Contrary to anecdotes in the financial press, income

of IPO firms is weighted more and sales is weighted less when valuing IPOs in the late 90s, compared to the late 80s.

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Impact of Ownership Structure on IPO Valuation

We substitute aggregate insider retention with ownership levels of four categories of owners. CEO Officers & Directors Venture Capitalists Other 5% Blockholders

We also examine the impact of changes in percentage ownership of above four categories of owners around the IPO.

Result: Greater the post-IPO ownership, and smaller the sales by each of these four categories of owners greater the IPO valuation.

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Table 5 Relation between IPO values and time period dummies, accounting variables, growth proxies, investment banker prestige, and detailed ownership variables Sample of 1,655 US IPOs completed in 1986-1990 and 1997-2001.
Independent Variables Intercept Boom Crash L(Income) L(Sales) L(BV) L(R&D) L(Price-to-sales comparable) Investment banker prestige CEO% Change OffDir% Change VC% Change Block% Change CEO% After OffDir% After VC% After Block% After
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L(Offer Value) 1.64 (14.7) .80 (21.0) .98 (17.5) -.08 (-5.7) .15 (10.3) .02 (1.8) .11 (4.1) .08 (6.0) .26 (23.1) -2.33 (-7.5) -2.00 (-5.4) -3.45 (-7.4) -1.50 (-5.2) .76 (4.2) .66 (3.5) 1.26 (5.7) .89 (5.7) 0.709

L(Total Market Value) 1.57 (12.2) .94 (21.7) .95 (14.1) -.10 (-5.9) .15 (8.4) .01 (4.6) .15 (4.6) .12 (6.7) .27 (20.8) -2.52 (-6.9) -2.38 (-5.58) -4.73 (-7.8) -1.96 (-6.0) .80 (3.7) .84 (3.7) 1.76 (6.3) .99 (5.3) 0.676

Adjusted R

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