I got a comment the other day about how an IPO price band is fixed, and I thought I should do a post on the book building process, which is used to determine the final price for a lot of IPOs these days.
The crux of book building is that through people’s bids – the issuers find out the highest price at which they can sell their IPO.
Let me take an example. Suppose you own a company that sells Walkmans and want to do an IPO for your company. You decide to offer 3,000 shares at a price band of Rs. 20 – 24.
Since everyone wants a portable way to listen music, love the fact that they can rewind and listen to the same song over and over again – you receive bids from 5 bidders in the following manner:
| Bid Quantity | Bid Price | Cumulative Quantity | Subscription |
|
500 |
24 |
500 |
16.67% |
|
1,000 |
23 |
1,500 |
50.00% |
|
1,500 |
22 |
3,000 |
100.00% |
|
2,000 |
21 |
5,000 |
166.67% |
|
2,500 |
20 |
7,500 |
250.00% |
You obviously want to sell at the highest price of Rs. 24, but at that price you will be able to sell only 500 shares. So, you come down a rupee, but see that there are only a 1,000 bids at Rs. 23, so you will be able to sell 1,500 shares at that price only.
So, you come down a rupee again, and see that there are 1,500 bids at Rs. 22, which means that you’ve received 3,000 bids from people interested in buying your IPO stock at Rs. 22 or higher.
Rs. 22 then becomes your cut – off price, and all bids above this price level are considered legal bids.
You will price your IPO at 22 or lower, but not at a higher price since you didn’t receive enough bids to be able to get your offering fully subscribed. This is known as the price discovery mechanism of the book building process, and the way most IPOs are priced these days.
In fact the example numbers I took above are very commonly found in prospectuses, and though in the real world, the numbers are much bigger, and complex this is the principle behind fixing the final price.
If 3 bidders bid 2000 each at 24 rs
How shares allot.
Simply amazing and easy to understand.
Something I was looking for.
Thank you Manshu 🙂
Wonderful – that’s great to hear – thanks Nidhi!
Hi, is the book-build method also somehow used to fix the price band? It seems so but it is not very clear. Please elaborate.
Yes it is. I’d recommend going through the post again and asking any specific questions you may have.
Please can you explain on which basis are the bidders chosen?
thans
It is on the basis of price matching and first come serve, so two bidders with the same price, the one who came first will get his order filled first.
Fantastic explaination . Thank you very much.
it”s a very usefull for me.
Manshu I want you to kindly fill one Questionnaire for completion my MBA research dissertation. I would like to request you to kindly provide me with your email id it would be helpful.
Thanks & Regards
Kuldeep W
[email protected]
Hello Manshu,
Can you kindly detail me about some of the IPO Valuation Methods?
Also kindly advice me which method is best as in Valuation Method.
Thanks
Kuldeep
Kuldpeep, IPO valuation is nothing but company valuation and valuation is a matter of opinion, not cash. There is no such thing as the best valuation method. It depends on a lot of factors and is a incredibly vast topic that people spend their whole life discovering.
Agree with Manshu to some extent. No method is best method. However, it is really advised to value a new company with 2-3 methods.
1. DCF is a must go for option as it finds out the intrinsic value of the company.
2. Company comparables – If there are existing companies within same industry listed on exchange, then PE RATIO or EV/EBITDA depending upon industry and debt should also be considered.
3. Transaction comparables – if any recent transaction has been done
Do above 3 (or whichever applicable) and take the cues from all three. Like you can put equal weight to all of them OR go for 0.50-0.25-0.25 value matrix.
You can never come up with precise value since process involves too many assumptions and each company is unique. However, you can come up with the fair idea of the value.
I hope it helps.
MoneyVriksh.com
I want you also to kindly fill one Questionnaire for completion my MBA research dissertation. I would like to request you to kindly provide me with your email id it would be helpful.
Thanks & Regards
Kuldeep W
[email protected]
that was very well explained. plz also post an example on how a Gren Shoe Option works…
That is very topical with the FB IPO just recently concluded. Here is a great link that will help you understand this. Please read the comments as well http://blogs.reuters.com/felix-salmon/2012/05/21/morgan-stanleys-2-4-billion-facebook-short/
It was very understandable. Your explanation with such a good example is appreciable. Thanks for you article. Please write up some more on book building if you know.
Is it possible Manshu to get your email address…
Thanks
You can use the contact form but I can’t guarantee that you will get a response.
Dear Manshu
the concept is very well explained. Further to what you have explained could you please let me know if underwriting is required for the book building process.
Thanks
hi manshu….i loved the way you wrote this article…..thanks to you ,finally i understand how bookbuilding works…..could you do an article on how bookclosure works….
Thanks Manshu..
It was simple & very helpful… I doubt , I would have got to know about this elsewhere.
Great! glad you found it useful Prasad.
Thanks Manshu for your neat and helpful explanation. I’ve one follow-up question on your above stated example: Rs. 22 has become the cut-off price and all bids at/above this price are legal bids. How much quantities will Bidders 1 & 2 get, and at what price? Will it be: Bidder #1 gets 500 @ 24, Bidder #2 gets 1500 @ 23 and Bidder #3 gets the balance 1000 @ 22? This way, the issuer gets the best deal. Is this correct?
Thanks. Its useful.
Glad you found it useful Ravi.
That was useful for a IT guy.
Glad to hear that it was useful!