Pricing IPOs very high can hurt a firm hard

MUMBAI: With the stock markets doing well, a number of companies have raised money through initial public offerings in the last few years. The logic is pretty obvious — when the markets are doing well, there is scope to raise more money. But is it the right way to go about raising money?

When a company decides to come out with a public offer, first and foremost, it needs to appoint a merchant banker to manage the entire issue.

As V Raghunathan and Prabina Rajib write in Stock Exchanges, Investments and Derivatives - Straight Answers to 250 Nagging Questions, “One of the first things a company does in an IPO (initial public offering) is that it appoints one or more investment or merchant bank(s)…. who provide a range of services in order to bring together companies and the investing public. The most important role of investment bankers is that of lead managers and underwriters…to the company.”

The role of an underwriter is very important in an IPO. “This is the process whereby the investment banker gives an assurance that the company will be able to raise the desired amount from the public, and the shortfall, if any, will be borne by them,” the authors write. The underwriters provide this service for a commission.

The underwriter, along with the company bringing out the IPO, decides on the price of the issue. The company, for obvious reasons, wants the share to be priced as high as possible. An underwriter, on the other hand, wants the share to be priced reasonably so as to ensure full subscription.

As the authors write, “There is often a conflict of interest here. Typically, the underwriters prefer a lower share price in order to ensure full subscription, while the company wants the price as high as possible.”

The companies want the shares to be priced as high as possible as they feel this would bring down the cost of raising equity.

“Such statements are made on the assumption that while a debenture issue may involve a cost of say 8 per cent, the cost of raising equity may be as low as 3 per cent… Consider a situation where a share with a par value of Rs 10 is issued at Rs 100 (the market value of the share is close to Rs 100).

If the company has paid a dividend of Rs 3 per share, implying a 30 per cent dividend, the yield translates to a mere 3 per cent ( i.e. dividend divided by market price),” write the authors.

So, is the cost of equity 3 per cent? The answer is obviously no. “If the cost of equity is interpreted as 3 per cent, this implies that the equity holders investing in the company’s shares are prepared to accept a return of 3 per cent on their investment. This is clearly absurd.

If debenture holders receive a return of 8 per cent on their investment, shareholders will expect even a higher return, to compensate for their higher level of risk on their investment.

Assuming that the shareholders expect a return of 16 per cent on their investment but receive a dividend yield of merely 3 per cent, how can they receive the balance 13 per cent? Obviously, this must come in the form of capital appreciation on their investment.

In other words, if a Rs 100 share is worth Rs 113 after a year having paid a dividend of Rs 3, then this constitutes a total return of 16 per cent. However, what circumstances should ensure that the appreciation of a share from Rs 100 to Rs 113, in course of the year after payment of Rs 3 as dividend, and when exactly would this occur? In reality, this will happen if the company has been able to earn a return of 16 per cent on the shareholder’s investment of Rs 100.”

So, what happens if instead of deploying the money raised at the shareholders expectation of 16%, the company is able to deploy it only at 9%.

“The situation implies that the company earns a stream of only Rs 9 per share. This stream of earnings per share capitalised at 16 per cent implies a market value per share of only Rs 56.25 (Rs 9/0.16). In other words, an investor who expects 16% return from the investment in this share will be prepared to pay only Rs 56.25 for it, since the company earns a stream of only Rs 9 per share.

Thus if shareholders require a return of 16 per cent on their investment of Rs 100 per share, but the share earns a return of only 9 per cent, the share value will drop to Rs 56.25”, write the authors. What this will do is that the next time the company wants to raise money from the stock market, it will not be able to do so at a good price. Hence, pricing the IPO high may not always be in the best interests of the company.