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JetBlue Airlines, a low-fare commercial airline, has planned to go public towards the end of 2001. During the process the firm had restructured their initial price from $22- 24 per share to $26 – 28 per share. Advantages / Disadvantages of the IPO Decision There are considerable advantages with obtaining equity through the IPO process.
There are, however, some drawbacks that also need to be taken into consideration.
Some of the advantages and disadvantages are: Advantages| Disadvantages| Equity value is established for the firm * Current shareholders can diversify personal portfolios| * SEC requires public disclosure of financial information (transparency) * IPO expenses| * Liquidity of stock increases| * Owner restricted to immediate cash-out| * Easier to raise capital in the future| * Sharing of future earnings with outsiders| | * Legal liability| Exhibit A in the appendix outlines some additional key advantages and disadvantages of going public through the IPO process. IPO Valuation Techniques
Deriving a value for an IPO is the critical part of the process. In both fixed price and book building offers some form of initial price must be determined by the investment bank. Key methods are used to determine the value of a company and thus the initial IPO price includes: * Discounting Methods: based on a firms intrinsic value (future cash flows) * Comparable Multiples Method: value based on similar publicly traded companies Using information from the case we perceived the IPO pricing of $24-26 was determined by using the comparable multiples approach.
Therefore, we will use the discounted cash flows method to determine an introductory price and evaluate whether it is in-line with the current proposed price. Exhibit B provides a description of each method. Discounted Cash Flow Recommendation It is our recommendation for the firm to set the price range for the IPO at the adjusted rate of $26 to 28. Although more value is achievable through a higher price, the lower range will meet the needs of the firm, maintain interest in the share, and possibly give large returns to the investors right away. Advantages and Disadvantages of Going Public through the IPO Process Advantages The partners can obtain a true value of the shares they possess in the company * Partners can remove their signatures from the lines of credit and thus, are no longer personally liable to the creditors * The overall financial condition of a company is improved as it brings in non-refundable money * A broader capital base gives the company more access to credit which gives the company an option to venture into new business opportunities * Capital raised in an IPO can be used to pay off debt and thus reduce the interest costs and enhance the company’s debt to equity ratio * The value of the stock may see an upward trend thus increasing the initial investor’s financial wealth * When a company goes public, it attracts the attention of the media and financial community thus providing free publicity and helps in creating a better corporate image * By going public and listing on a stock exchange it can directly foster public reputation in general Disadvantages The market is extremely unpredictable and an unsuccessful IPO can result in a great loss of time as well as money for the company * The ownership of the partners is dissolved and they become mere employees who are responsible to the shareholders and Board of Directors * Continuous dealing with shareholders and the press is a time-consuming process * Shareholders judge the performance of the company on the basis of the profits and stock price and may cause managers to overlook the long-term strategic objectives * The company needs to make nation-wide presentations about its performance to the interested shareholders, brokers and the investment bankers * The company’s continued success may bring a lot of close scrutiny by the public * Large amounts of fees and expenses are associated with a public company on a continual basis – commissions, advertising costs, securities exchange fees etc. Exhibit B: IPO Valuation Techniques Discounting Methods Theoretically, the price of a share is derived by discounting all future cash flows that accrue to shareholders. These techniques are used throughout industry; however, they do suffer in practical application due to the risk associated with forecasting both revenue and expenses (Draho, 2004). The two most frequently used discounting methods include the discounted free cash flows (DCF) and a residual income model (RIM). * Discounted Free Cash Flows Free cash flows are defined as the cash flows from operations after investment in working capital and any capital expenditures.
These cash flows are considered more appropriate than accounting earnings which include non cash items such as depreciation that cannot be used to pay shareholders. Cash flows are used to pay dividends and thus capture true value for the investor. These cash flows are then discounted using a risk adjusted rate. The rate is estimated either by using the capital asset pricing model (CAPM) for a 100% equity company or by calculating the weighted average cost of capital of the firm’s debt and equity (Geddes, 2003). * Residual Income Model The DCF model requires accounting earnings to be converted to cash flows. This is considered inappropriate as accounting values do not take into consideration the time value of money and may be subject to manipulation by way of accounting methods.
The RIM is similar to the DCF method in that both methods use a risk adjusted discount rate. The RIM model, however, utilizes the difference between the realized earnings and the expected earnings, where the expected earnings is the cost of equity multiplied by the start of period equity book value (Draho, 2004). Comparable Multiples This is the most common method used by investment banks to value IPO’s. Its fundamental approach is the comparison of ratios of companies that operate in similar businesses that possess the same characteristics of risk, current and future profitability and growth prospects. There are number of ratios that can be used under this method, the most common being: * Price/Earnings multiples * Price/EBIT Market value/Book value * Price/sales The successful application of this method lies in choosing an appropriate comparison company. One method used by practitioners is to select up to 10 company’s operating within the same industry and to use the group’s median multiple to value the issuer. The second and most common method is to select 3-4 companies that are direct competitors within the particular industry to the issuer. The third method is to use multiples of firms that have recently gone public assuming all issuers share common valuation multiples. The comparable multiples method is a popular method to value an IPO due to its simplicity and accuracy.
With the use of multiples there is no need to estimate the cost of capital, neither is there a need to depend on forecasted earnings and assumptions of valuation models. The use of multiples is supported by the assumption that relevant ratios capture the markets estimate of risk and growth. References Bruner, R. F. , Eades, K. M. , & Schill, M. J. (2010). Case Studies in Finance: Managing for Corporate Value Creation. New York, NY: The McGraw-Hill Companies. Damodaran, Aswath. “Damodaran Online: Home Page for Aswath Damodaran. ” Welcome to Pages at the Stern School of Business, New York University. Web. 1 July 2010. <http://pages. stern. nyu. edu/~adamodar/>. Draho, J. (2004). “The IPO Decision: Why and How Companies Go Public”. Cheltenham, UK: Edward Elgar Publishing.