1 Impact of Fundamentals on IPO Valuation Impact of Fundamentals on IPO Valuation Rajesh Aggarwal Sanjai Bhagat Srinivasan Rangan

2 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. 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. 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.

3 Motivation “Early profitability is not the key to value in a company like this (Inktomi).” “Early profitability is not the key to value in a company like this (Inktomi).” Jerry Kennelly, Chief Financial Officer of Inktomi Inc (1999). 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.” “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. Gove (2000) in Red Herring.

4 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? 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?” 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?”

5 Discounted Cashflow Valuation where, n = Life of the asset CF t = Cashflow in period t r = Discount rate reflecting the riskiness of the estimated cashflows

6 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? 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 Income Book value of equity Book value of equity Sales Sales R&D R&D Industry price-to-sales ratios Industry price-to-sales ratios Insider retention Insider retention Investment banker prestige Investment banker prestige Were the valuation of these variables different for tech firms, internet firms, and loss firms? Were the valuation of these variables different for tech firms, internet firms, and loss firms?

7 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 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. 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. 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. 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 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. For loss firms, we expect income to be valued less, and insider retention and IB prestige to be valued more.

8 Model Specification Dependent variable choices Price-to-earnings ratios Price-to-earnings ratios Problem: Leads to elimination of IPOs with negative earnings from the sample. 63% of IPOs during have negative earnings. Problem: Leads to elimination of IPOs with negative earnings from the sample. 63% of IPOs during have negative earnings. Price-to-sales ratios Price-to-sales ratios Problem: Some IPOs during have zero or extremely small values for sales. Problem: Some IPOs during have zero or extremely small values for sales. Price per share Price per share Problem: Investment bankers estimate total offer value first and then partition it somewhat arbitrarily into price per share and shares outstanding. 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.

9 Model Specification Dependent variable choices Offer value in millions of dollars. Offer value in millions of dollars. Problem: non-normality. Problem: non-normality. Logarithm of Offer value. Logarithm of Offer value. Logarithm of first-day Market value. Logarithm of first-day Market value.

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

11 Model Specification Boom = 1 if the offer date is during 1/1997-3/2000, and 0 otherwise. Boom = 1 if the offer date is during 1/1997-3/2000, and 0 otherwise. Crash= 1 if the offer date is during 4/ /2001, and 0 otherwise. Crash= 1 if the offer date is during 4/ /2001, and 0 otherwise. Loss= 1 if income before extraordinary items is negative, and 0 otherwise. Loss= 1 if income before extraordinary items is negative, and 0 otherwise. Tech = 1 if a firm belongs a technology industry, and 0 otherwise. Tech = 1 if a firm belongs a technology industry, and 0 otherwise. Internet = 1 if a firm belongs to an internet industry, and 0 otherwise. Internet = 1 if a firm belongs to an internet industry, and 0 otherwise.

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16 Value of IPO Income

17 Results Controlling for IPO fundamentals and allowing for different valuation of these fundamentals across different time-periods, 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. Average IPO valuations in the late 90s were not statistically different than those of the late 80s. Naïve 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. Naïve 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 after controlling for endogeneity of insider retention and investment banker prestige. (Appendix Table 2) Above results hold in robust regressions. (Appendix Table 3) Above results hold in robust regressions. (Appendix Table 3)

18 Results Controlling for IPO fundamentals and allowing for different valuation of these fundamentals across different industries, Controlling for IPO fundamentals and allowing for different valuation of these fundamentals across different industries, Tech IPOs are valued less than non-tech IPOs. Tech IPOs are valued less than non-tech IPOs. Income and insider retention are valued more for tech firms. Income and insider retention are valued more for tech firms.

19 Results Controlling for IPO fundamentals and allowing for different valuation of these fundamentals across different industries, Controlling for IPO fundamentals and allowing for different valuation of these fundamentals across different industries, Internet IPO valuations were not statistically different than non- internet IPOs. Internet IPO valuations were not statistically different than non- internet IPOs. For internet firms, insider retention is valued more, but investment banker prestige, surprisingly, is valued less. For internet firms, insider retention is valued more, but investment banker prestige, surprisingly, is valued less.

20 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. 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.

21 Impact of Ownership Structure on IPO Valuation We substitute aggregate insider retention with ownership levels of four categories of owners. CEO CEO Officers & Directors Officers & Directors Venture Capitalists Venture Capitalists Other 5% Blockholders 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. 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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