Investing 101

## Initial Public Offerings

Every public company in the world started somewhere: whether it was in a garage like Apple or a basement like Amazon, every company started as private. In order for the company to grow into the size it is today, a major step in the process is going public. This involves offering shares/equity/part ownership to the public in exchange for funds. The process of issuing shares to the public in exchange for funding is done through an Initial Public Offering (IPO). Companies must follow regulations set forth by the Securities and Exchange Commission (SEC) as once a company goes public, its walls and information become transparent. Prior to an IPO, an investment bank is hired to gauge demand for the company’s shares and decide on its listing price. An IPO is especially important for its founding members and investors as it can be an exit strategy to gain profit from their initial investment. 

However, before a company goes public, it must assess whether it is mature enough to handle SEC regulations and the responsibility to public shareholders. Any private company with strong fundamentals and profitability potential can qualify for an IPO as long as it’s ready to cover the cost, risk and financial disclosures. The largest IPO in the world belongs to Alibaba, which went public in 2014 and was valued at $21 BILLION. 

## Benefits and Drawbacks of IPOs

An IPO’s primary benefit to any company is the amount of funds generated from the sale of shares to the public. Additionally, an IPO increases the company’s exposure publicly, which can help drive revenue. Lastly, the required transparency for an IPO, allows companies to gain a favorable image and improve their credit ratings.

However, this can also be a drawback. With the extra transparency, time and effort must be put in to disclose all necessary information. This can cause issues if the disclosed information is false in any way. Additionally, the price of the company’s shares are constantly on everyone’s mind (since they get compensated with stock options) and this can distract employees from achieving real results. Lastly, the benefit from going public must outweigh the costs, as the costs of going public are high. 

SPAC: Another way for a company to go public is through a Special Purpose Acquisition Company. Such a company has no commercial operations, it’s only responsibility is to raise capital through an IPO with the purpose of acquiring a private company. These companies are also known as blank check companies. For example, Holicity, a blank check company, had agreed to take Astra Space public through a SPAC deal. This way, Holicity went public, raising money from public investors, and then reverse-merged into Astra Space, contributing all that money to Astra. As a result, Astra became Holicity in the stock market. SPACs usually have 2 years to complete their acquisition or else money will be returned to investors.

*Disclaimer: the author of this article owns shares of Astra Space 

Every public company in the world started somewhere: whether it was in a garage like Apple or a basement like Amazon, every company started as private.

Initial Public Offering (IPO)

Stock and Equity

There are different ways to value an equity security - some are straightforward while others require more work. One can easily be overwhelmed by the number of valuation methods but you can split them into 2 categories: absolute valuation and relative valuation. 

## Absolute Valuation

Absolute valuation aims to calculate the “intrinsic value” of a company based on projections and assumptions about the future performance of a company. This method looks at company fundamentals, such as dividends, growth rate and cash flow, to determine the true value of a company. However, a company does not always trade around its intrinsic value due to factors like momentum and macroeconomics. For example, AliBaba, one of the world’s largest online commerce companies, is fundamentally valued at a much higher price than the share price it is currently trading at. This is because the company is facing pressure from the government and this causes uncertainty about the future performance of the company. 

### Methods:

Dividend discount model - the price of a stock is equal to the next year’s dividend divided by the difference between the cost of equity and constant growth rate. 

Discounted cash flow - calculates the sum of the present value of all expected future cash flows, discounted at the weighted average cost of capital to determine the enterprise value of a company and eventually its stock price. 

Residual income model - the price of a stock is equal to the present value of future residual flows discounted at the cost of equity. 

Asset-based model - calculates the net asset value of a company based on the difference between the market value of its assets and liabilities. 

## Relative Valuation

As the title says, these methods value a company based on the valuation of similar companies in the same industry. This involves calculating ratios and multiples for several companies and then comparing them to each other. An example of a ratio is the price-to-earnings ratio(P/E) which measures its current share price relative to the earnings per share (EPS). For example, Ford’s P/E ratio is 16.00 but General Motors P/E ratio is only 5.91. This indicates that General Motors, relative to Ford Motor Company, is undervalued. This method of comparing ratios is much quicker and easier than any of the absolute valuation methods. 

When analyzing an equity, the best way to start is by seeing the relative valuation of your company versus its comparables. If you want to take it step further, then use an absolute valuation method to estimate the intrinsic value and share price of your company. 

Valuing Equity Securities

Absolute Valuation

Methods:

Relative Valuation

Initial Public Offering (IPO)