The Valuation of an IPO

Finance and Stuff

There are multiple ways you can value a company. Arguably, the most popular way is to calculate all the cash the business will generate in the future and determine their current value. $100 in hand today has a higher value than $100 in hand in a year later. The rate of return is the payment or fees you demand for lending or investing your money. To make it simple, if your rate of return is 10%, you’d want 10% every year on the money that you provided. So, if you investment is $100, one year later, you’d want the money to grow into $110. In other words, receiving $99 one year later would be equivalent to receiving $90 today.

This rate of return can also be expanded into cost of capital or more specifically, Weighted Average Cost of Capital, WACC. Businesses are usually financed by both debts and equity. This weight comes from the debt and equity mixture. Debt is what company borrows with a promise to pay interest. Equity is what owners invested in the business.

So, the other day, we had to solve a case in the “Financial Information Analysis” course final. Let me link to the original case, IPO valution of JetBlue Airways. Everything was alright except the equity. the equity in the balance sheet, or the book value was negative. Equity is what shareholders or owners stake in the company. So, how can owners have a negative stake in the company?

Let me explain.

For simplicity we can consider that everything company own is called asset. Asset is either funded from loans (Liabilities) and Shareholders (Equity). So, you can say that,

Asset = Liability + Shareholders Equity

When loans get bigger than company asset, you can see that equity must be a number. So what does it mean in real life?

Negative equity means now that company can’t pay off the loans with the assets it have, it must take more money from shareholders. In other words, shareholders do not have any claim on the company assets anymore. Rather, company has claims on shareholders personal wealth. This gives a rise to the type of company named Limited Company.

So ,What is a Limited Company?

In real life though, when you buy a stock, you are protected by law. The maximum amount you can lose is the amount you invested. If company can’t pay off it’s debt, you do not have any liability to the company. The company will use all you invested, but can’t ask for more. These companies are called Limited Liability Company. In US, termed as LLC, in Bangladesh, Limited Company. Every company in the stock market is a limited company.

If it’s not a limited company, you’re in trouble. Company must pay every ounce of it’s debt. No excuses. You own 50% of the company and company can’t pay off the debt using the assets. You have to pay the remaining 50% debt out of your pocket. Limited companies has big advantages over others for this reason alone. If anything goes wrong, declare your company bankrupt and be done with it. Lenders will not ask you to pay using your personal wealth. They will take the company away from you though.

What About The WACC

Usually market value of equity should be used, but we had access to only book value. The book value of equity is negative. So WACC could not be calculated. Because negative equity will assign a negative weight to equity. Thus reducing the cost instead of raising it. So, what we needed to do is use another company’s or Industry-wide capital structure. The process is not 100% right but it’s a start.

The reason it’s not right is because two similar companies may have completely different company-specific risk. Negative equity is one of the risks of JetBlue that may not be reflected in a industry WACC. So, the WACC I am proposing to use here is definitely not the right one.

The Verdict

I did not get the proper IPO price of JetBlue. Probably due to the fact that, WACC was not accurate for starter. I had to calculate everything using a Casio calculator from my engineering days. There were scope for error. I know that MS Excel or R is a better bet. Sadly, I was in the exam hall so only access I had was to my pen, paper and calculator.

It was a nice course. Probably one of the best courses I took in graduate level. I am kind of sad that it’s over. So, only 4 finals and I will be done with the coursework. Just a few weeks to go starting with the Corporate Strategy on Saturday.

Wish me luck.