Introduction to IPO Screening: Company Financials

 

Assessing companies who are planning to list on a stock exchange is often a lot more difficult that one that has been listed for years. There are a multitude of reasons, one of which, is an absence of broker forecasts and thus, financial visibility. However, that precise reason means that companies undergoing Initial Public Offerings (IPOs) are prone to sharp share price swings in their first few weeks of trading, as both institutions and private investors make their decisions as to whether the company holds upside, or downside potential, and take their positions. Therefore, being able to screen the basics of an IPO is a useful tool. The 3 part series will form an introduction to IPO screening, and will point out the basics that investors should look for. This is the final part of the series

Assessing Company Financials

The final part of the introductory screening, is to look at the companies financials. This is the most important part of any screening process, as investors need to be able to make a decision as to whether a company is undervalued or overvalued before the wider market is able to make its final decision. The volatility of newly listed stocks post-IPO (over 0-6 months in particular) suggests that the market's initial valuation (the IPO valuation) is very rarely in line with what investors are willing to pay for the stock. That opens up an opportunity to profit, ahead of the market. In addition, given the lack of broker forecasts pre-IPO, it is integral that investors can spot future trends within statements that are inherently historic. Once again, this tutorial will focus upon non-resource, profitable companies.

Finding a Starting Point

When starting to value an IPO, there are two approached that can be taken. The first is to use the placing price along with the financials, to see whether the current valuation is attractive. The second is to use the financials and formulate your own share price range where you believe fair value lies, and then compare to the placing price. Both of these methods have their own merit, and one can be more useful than another in certain situations. However, for simplicity, this tutorial will focus upon the first method, where we use the placing price as the reference.

Given the risks of repeating the information that can be found in the other site tutorials here under the Fundamental Analysis section, I won't fully detail all the valuation methods that you can use to determine whether a company valuation. The reason for that is that they apply for a newly listed company, and a company that has been listed for a longer period of time. I will however, skim over the valuation measures, and add additional details that are likely to be found within an admissions document.

Given that the company risks will impact upon the valuation arrived at, I'll follow on from the last review with SafeStyle (LSE:SFE), where we have already established that there were no overt risks. Whilst there were a few covert risks, these won't materially affect any valuation. It therefore gives us a good platform to work off. SafeStyle's admissions document can be found here. The financial details can be found under the dedicated 'Financial Information' section of an admissions document.

The easiest place to start when looking at companies with positive earnings is with the PE Ratio, which we can later adjust for several variables. As before, we know that SafeStyle is a UK-based manufacturer and installer of doors and windows.

To work out the PE Ratio, navigate to the financial information section and find the column for the most recent set of results. This will either be the last FY column, or the last HY column. If you have the HY column, the easiest way to predict a FY result is to double the figures. However, do check whether there is any seasonal weighting. Does the company generate a larger proportion of their figures in H1/H2? If so, you can adjust for that. In SafeStyle's case, there is unlikely to be much seasonality.

We need to calculate two PE Ratios: the trailing PE (based on the last FY), and the forward PE. I've highlighted the two relevant figures in the picture on the right. Assuming a company is growing, the trailing PE will be larger than the forward PE. Do refer back to the other site tutorials if you require further help.

The trailing PE can be found by dividing the 2012 profit figure by the "Number of Ordinary Shares in issue at admission", which we found in the first tutorial. This figure is 77,777,777 for SafeStyle as per page 4 of their admissions document. The EPS figure comes to 9.12p, which, with a 100p placing price, put the company on a trailing PE ratio of 10.96.

Doubling the 6-month figure and performing the same action gave an EPS figure of 15.34p, which equated to a forward PE ratio of 6.52. The next step is to check this against sector competitors or to use an intuitive PE ratio range. For simplicity let's use intuition, although a sector comparison would be more accurate - bear in mind though that the comparable companies could be undervalued/overvalued! Generally, 'unexciting' companies trade on forward PE ratios between 12 and 16. The point within the range depends on a variety of other factors. Given the growth of SafeStyle, I reckon that a PE ratio of around 14 would have been fair, given that the industry is quite competitive, but the company is highly profitable and growing. The PE ratio range differs between sectors. Technology stocks, for example, have a higher range of PE ratios. Using the 15.34p EPS figure, that gives a supposed price target of 214.76p at the time of the IPO, just using the figures that the company provided. The final step for finding the starting point is to check back over the 'Current Trading' part of the admissions document to ensure that there is nothing that will mean the H2 performance is significantly different compared to H1. As below, there is nothing to cause concern.


We therefore have our starting point - a valuation to use assuming that all is well, and that no other variables detract from the outlook. SafeStyle's starting point is relatively easy to reach. If a company has not issued a half-year set of results, then you need to examine revenue growth trends, margin trends and the current trading section to try and gauge what sort of growth to pencil in.

Adjusting for other variables

To keep it simple, there are a number of other variables to be accounted for that could adjust the price target up or down. Refer to the other site tutorials if you need assistance in locating the various valuation variables. Factor in any overt and covert risks previously found at this point. On the whole, there are no pressing ones to include given that the PE Ratio of 14 reflects the industry risks (such as high competition).

- The cash/debt pile
Use the most recent figure available. SafeStyle's most recent figure at the time of the IPO was £10.60m in net cash. That represented a significant part of the £77m market cap at the time of the IPO. Therefore, it is worth stripping some of that cash out and defining it as 'surplus'. How much you strip out is down to intuition, but it shouldn't really be more than 75% unless the cash pile is substantial (versus the market cap). For SafeStyle, 50% of the cash could be stripped out. Doing so leaves an ex-50%-of-cash share price of 93.1p, which drops the PE ratio down further. Therefore, around 6.9p can be added to the price target. New price target = 221.7p. If the company has a large net debt pile, add this into a per-share figure and add it to the workable share price.

There is an important point when looking at this section. When companies list, they often raise cash, and this cash is not shown on the historic balance sheet. Therefore, you need to add the "Net Proceeds" that we found in the first tutorial, to the cash balance.

In SafeStyle's case, this does not need to be done because the listing was an exit strategy for pre-IPO investors. Therefore, the shares offered in the IPO were from the pre-IPO investors selling down their stake. These investors received the proceeds rather than the company. A company will outline whether they are due to receive any net proceeds near the start of their admissions document.

- Is the rest of the balance sheet in good shape?
For Safestyle it is. Therefore, do not adjust the price target. If the balance sheet is not in good shape (i.e. where there are a lot of liabilities versus assets), then the price target can be adjusted downwards.

- Is the profit translating into cash flows?
This can be checked through looking at a company's cash flow statement. Once again, don't add any upside here - just subtract downside in the case that profits are not being converted into cash generation

- Check other traditional valuation measures
Is there an outstanding dividend? Does the company have trade losses? These are just a couple of examples of points that can impact the price target. For SafeStyle, there aren't any traditional valuation measures that should cause a deviation from the price target of 221.7p established earlier.

- Is the company prone to exchange rate fluctuations?
This can be a significant point. If a company admits that it is open to exchange rate fluctuations, then this is an additional risk. A company is susceptible to exchange rate fluctuations when it sells its good/service outside of the UK.

For example, if a UK company sells books to individuals in the USA via bookstores, it will take payment in US Dollars. However, the company will report its revenues in UK Pounds on its income statement. It therefore has to translate the US Dollars revenues into UK Pounds revenues. Exchange rates fluctuate, sometimes significantly. If the US Dollar appreciates materially versus the Pound, there are more Pounds per US Dollar. That is good for the bookstore company. If the US Dollar depreciates materially versus the Pounds, there are less Pounds per US Dollar. That is bad for the bookstore company. Check the exchange rates that the company is susceptible to, and check the exchange rate graph to see how that has changed over time. Is there a chance of a material appreciation/depreciation?

A company can 'hedge' against these movements by having certain complex financial contracts in place. These can mitigate the losses that they may experience. In addition, if a company operates in a wide range of countries, to similar extents, the overall exchange rate risk is diminished, compared to if the company only operates in one non-UK country. You can factor the exchange rate risk into the target price.

In the case of SafeStyle, a quick CTRL+F for 'Exchange rate' [or 'Currency Risk'] brings up the following text. The company's sales are in the UK so it is not susceptible to exchange rate fluctuations.


On the other hand, Mincon's (LSE:MCON) admissions document had the following warning about exchange rate risk, which should have prompted investors to lower their expectations. In particular, the South African Rand has been extremely weak over recent years, with extremely large falls in the rate versus key currencies. That creates margin pressures that the company have to deal with.

- Is the company dependent upon a few key customers for a large proportion of their revenues?
This is another fact that can found within an admissions document. In general, large proportion refers to over 10% of revenues. If there are multiple that account for over 10% of revenue, that is a risk, because if they stop working with the company, then a hole will be left in the revenue figure. That could prompt the company to miss market expectations. Given the customer base that SafeStyle works with, it is of no surprise that no customers account for a material percentage, so no further PE ratio risks have to be factored in

Does the company pass the screening?

As before, it is important to recognise that the points listed above are only of a long list. However, they are not all particularly obvious to spot, and these tutorials give a glimpse of the many forms that risks can take, and what to include in a basic valuation. Indeed, this basic valuation, that could have been completed prior to listing once the admissions document was released, led to a price target of 221.7p being derived. How has SafeStyle performed since?

The low initial valuation seems to have been welcomed by the market as investors have bought up the shares, driving them higher. That has been fuelled by major institutional interest. As per the chart, the company's shares finished the first day of trading at a much higher level than the placing price, at just shy of 140p. SafeStyle currently trades just above the 200p mark having peaked around 218/9p. Forecasts for next year are for a further lift in profits - without completing additional research it is likely that the company continues to trade on a modest rating.

Ultimately, there are many different ways to value an IPO, and this technique only works on profitable, non-resource companies. Unprofitable companies, resource companies and blue-sky companies often require a different valuation strategy. For resource companies that involves deriving a value for their assets. For the other two types, it can be more difficult. This three part introduction to IPO screening should hand investors the basic tools needed to form an opinion on a company, before the wider market has developed its own opinion.