Managing Director & Senior Partner; Global Leader of Mergers & Acquisitions
This article—the second in a series exploring the practicalities of going public—looks at what drives a premium IPO valuation. The previous article, “Anatomy of an Ideal IPO Candidate,” dispelled some myths about barriers to going public.
Planning for an initial public offering is a lot like planning a wedding. Some factors that affect success, such as investor sentiment, are beyond a company’s control, while others, such as the offer price, can only be dealt with shortly ahead of the big day. But many others should be addressed proactively with thorough planning over an extended period. Indeed, new research by BCG finds that some of the most important factors driving a premium IPO valuation are those for which preparation should begin well before the opening bell rings.
Our research focused on the issuer’s valuation multiple as determined by the offer price on the listing date. If the multiple exceeds the industry average at the time of listing, the issuer has listed its shares at a premium. Among European companies that went public from 2010 through mid-2017, 56% achieved a premium valuation, although there were wide variations among industries. The remaining companies—almost half—failed to reach the average multiple for their industry when they listed their shares.
What are issuers that achieve a premium valuation doing better than their peers? To find the answer, we analyzed the influence of 24 factors in three categories: issuer characteristics, operational performance, and capital structure and financial ratios. (See Exhibit 1 and the sidebar, “Study Methodology.”)
BCG’s study sampled 497 IPOs at the ten largest stock exchanges in Europe from January 2010 through June 2017. To control for very small IPOs (mainly technology and pharmaceutical companies tapping the market for seed money), we excluded IPOs of companies with less than €5 million in annual revenue in the year before the offering. We also excluded financial services firms because of the limited comparability of their revenues and margins.
We compared each issuer’s valuation multiple, as determined by the offer price on the listing date, with the average val-
uation multiple of its peers in the relevant Stoxx Europe 600 sector index. First, we determined whether an issuer listed at a premium or a discount valuation relative to the industry average. Second, we calculated the exact magnitude of each issuer’s premium or discount.
To ensure that results were not distorted by differences among companies and accounting standards, we separately analyzed four trailing multiples: EV/revenue, EV/EBITDA, EV/EBIT, and P/E. The four analyses yielded similar results. For simplicity, we focus in this article on the results relating to EV/revenue.
To understand what influences an IPO valuation, we looked at how it correlates with 24 company characteristics. Those characteristics with a significance level of 1% or 5% were considered to be influential. To ensure the robustness of our analyses, we conducted several statistical crosschecks, such as multivariate tests.
We recorded results for the overall sample and at the industry level. Our industry-level analyses sought to understand whether the factors that influence a valuation are different for growth industries (such as health care and technology) than for more mature industries (such as building materials, chemicals, industrial goods, oil and gas, and transportation).
Our study confirmed that some intuitive factors, such as strong revenue growth and above-average margins, are indeed highly influential. But we also found that some less obvious factors, including organizational complexity, leverage, and expected dividend yield, are equally important. The relative importance of each factor depends on the maturity of the issuer’s industry and the size of the company. Surprisingly, some factors that are generally regarded as important in the IPO process, such as timing and the number of underwriters, appear to have little or no influence on the IPO valuation.
We sought to understand which characteristics influence an issuer’s valuation on the IPO date. Among the characteristics we explored, three stood out as having the greatest influence.
We found that VC-backed companies have a higher likelihood of receiving a premium valuation than other companies (78% versus 54%). VC backing appears to boost investors’ confidence that the issuer can deliver on the promises in its equity story. Further, investors seem to regard VC backing as certifying higher growth expectations and validating the claims in the business plan and equity story.
We found even clearer implications relating to ownership by a PE firm. In the overall sample, PE backing had a statistically significant influence on the likelihood that issuers would receive a premium valuation: the EV/EBITDA multiple for PE-backed companies exceeded that of other companies by 1.6x. Investors may have greater trust in PE-backed IPO candidates because they believe that PE ownership focuses the entire company on growth and value creation. Or it may be that PE firms are simply more aggressive in demanding and achieving higher multiples for IPO companies exiting their portfolios. The results varied by industry cluster, however. PE backing did not significantly influence the valuation of companies in growth industries, but it strongly promoted premium valuations for issuers in more mature industries. PE backing appears to help large, mature companies secure share placement without having to price at a discount on the IPO date.
It is clear that investors are looking at an issuer’s characteristics in order to find clues about the company’s intrinsic ability to create value. An IPO candidate must take several steps to determine the characteristics that matter most given its industry context and address them before the IPO date. First, it must identify which investor groups to target and determine their expectations with respect to key characteristics. It can then ensure that its equity story addresses these topics and mitigates investors’ concerns. For issuers with a complex structure or multiple business models, it is especially valuable to present a convincing and reassuring discussion of company characteristics. Very large companies can use a convincing equity story to rally sufficient demand, so that they can list their shares without pricing at a discount to support share placement.
Unsurprisingly, strong revenue growth and above-average margins promote a premium valuation. But investors are not shortsighted. They want to see a convincing track record for sales and profits leading up to the IPO, ideally starting two years before the offering.
Because issuers are not able to disclose their forward-looking business plan in most jurisdictions, the pre-IPO revenue development needs to provide investors with sufficient assurance that the company can sustain its growth in the years ahead. An IPO candidate’s equity story should reflect its revenue development and show that historical growth has been driven by strong fundamentals.
Realizing above-average margins and revenue growth is challenging and requires hard work and a disciplined approach in the years before the IPO. When planning for a public listing, the company should be even more diligent than usual in preparing and executing a sound business plan. The plan should support the company’s growth ambitions with detailed initiatives and place special emphasis on the areas that the target investor groups care about most. A stringently executed business plan provides the basis for a strong financial section in the equity story and boosts investors’ confidence that the company’s ambitions are supported by a credible track record. It will also help executives deliver against expectations once they are in the glare of the capital markets after the IPO.
Because capital structure and other financial ratios offer important insights into a company’s setup and establish expectations for future investment returns, they strongly influence IPO valuations. However, we found that investors’ expectations are often determined by the maturity of an issuer’s industry.
To optimize their capital structure for an IPO, companies need to make a variety of difficult decisions and tradeoffs. For example, if target investors expect a high dividend yield, the company might need to reduce capex and accumulate cash on its balance sheet for higher payouts. The appropriate tradeoff between reinvesting cash and paying dividends can theoretically be made shortly before or after the IPO date. However, if the payout strategy is not consistent with the issuer’s historical profile and business plan, investors will question the substance of the dividend and investment strategies. To make a convincing case to investors, the company’s IPO-adjusted capital structure and payout strategy should be reflected in its business plan one to two years before the IPO.
Several factors that are seen as important considerations in IPO planning and execution have little or no influence on achieving premium valuations.
An IPO candidate cannot address all the factors that influence a premium valuation. It is not practical—or even advisable—to completely overhaul a company’s setup, strategy, and financial structure leading up to an IPO. Nor is there a single initiative that will serve as a magic bullet to guarantee a premium valuation. Instead, the company must find the appropriate middle ground. It should thoroughly review the key drivers of a premium valuation and prioritize the factors to address on the basis of impact and feasibility of implementation. Putting in place a sound and stringent business plan to promote superior growth and margins is a no-regrets move. The plan is crucial to promoting a high share price far beyond the listing date, because it guides investors’ expectations and sets the stage for the company’s capital markets communications for many quarters going forward. Determining the value of other adjustments, such as divesting business units to reduce complexity before the IPO, requires a deeper assessment.
To juggle the varied (and potentially conflicting) factors affecting the IPO’s success, the issuer should establish a detailed timeline and project plan 15 to 24 months beforehand. The plan should comprise three phases. (See Exhibit 3.)
Our study shows that multiple factors influence whether an IPO lists at a premium valuation. No IPO candidate can control each one in an optimal way. But every issuer can improve its chances of achieving a premium valuation by identifying the most important factors in its industry context and addressing them through thorough and comprehensive planning well before the IPO date. Strong IPO candidates are made, not born.