Explaining IPOs

(*freely inspired from Mr Oosterlinck’s Corporate finance course / MA1 Management Science)

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Following the historical initial public offering on the 18th of September of Alibaba, one of the world’s biggest e-commerce company, many other „e-companies” like Zalando or Rocket Internet decided to follow the same path. The first of October, Zalando, a German e-commerce retailer decided to go public. A day later, it’s former business incubator, Rocket Internet did the same operation.

The German companies’ IPOs occuring few days after Alibaba’s one are not hazardous. Indeed, we can clearly assume that the Chinese e-commerce company served as a subject test and its share price evolution reflected the investors’ thoughts about this type of „tech-companies”.

But before going further into the analysis of Zalando and Rocket Internet shares evolution, we are first going to look at IPOs from a theoretical point of view: What is an IPO and why do companies decide to go public?

An Initial Public Offering is a decision of a company to go public. It means that the company, for the first time, is going to issue equity to the public(=the capital markets). But why private companies suddenly decide to lose part of their ownership and make such a move? We can quickly guess the answer of this question: going public is attractive both for financial and „reputation” concerns. On the one side, it allows a company to raise capital quickly (to pay off debt, for instance) and on the other side, it increases its visibility and it gets more „attention”. It also allows venture capitalist to use IPO as an exit strategy to cash in their investment. But going public is not a win-win game. There are some important drawbacks of IPOs: loss of ownership and also, for venture firms the potential apparition of conflicts arising from heterogeneous interests of firm owners.

Technically speaking, how do companies go public? There are different steps in this process. First, the private company needs to contract with an intermediate between the company and the investors, the underwriter. There are different types of contract existing: firm commitment, best effort. Both methods have their own advantages and drawbacks.

Then, a registration statement has to be filed to the competent administration (the SEC in the US, for instance) detailing the IPO and the company in general: price offered for the IPO, business model of the company, etc.

Also, the potential buyers to whom the stocks are going to be sold to need to be identified. Finally, a correct price has to be proposed for the stocks issued. This final part is quite tricky and probably one of the most difficult task. Indeed, estimating a private company’s value is by its nature, really difficult: what parameters and criteria to use in order to value something that has really never been valued before. It is not the case for Seasoned Equity Offerings (SEOs) for example, because in this case the calculation of new shares value is made on the basis of the previous one. And also because of the asymmetry of information between the issuer and the investor, IPOs tend to be underpriced.

Going back to the cases of Zalando and Rocket Internet, it is interesting to look at the share price evolution of the companies right after their market introduction.

In the case of Zalando, we can assume there are two main reasons for going public: First, Alibaba „led the IPO charge” of tech companies and it may have spurred other companies to do the same in order to beat Alibaba’s IPO. Second, despite the consecutive negative net profits of the German online retailer since its very first days in 2008, the company reported a first ever positive net result for the second quarter of 2014, right before its IPO. This good news would further increase the confidence of investors in the excellent future financial position the company has.

Concerning its IPO pricing, a first price estimation of 18 to 22,5€ was made based on the expected demand of investors. Then, on the day of the IPO, the share were finally priced at 21,5€, valuing the company at approximately €5.3 bn.

Graph 1.1
Graph 1.1

The graph 1.1 describes the evolution of the share price of Zalando for the period covering October to April. Some relevant information can be observed. First, it can be seen that contrary to Alibaba, share price evolution plummeted at the very beginning of the trading days: indeed, despite a small increase at the closing of the first day from 21,5 to 21,6€, price dramatically fell down to less than 17,5€ few days later. One reason for this under valuation can be explained from a theoretical point of view (that is, asymmetry of information). But we could advance another reason: the consecutive negative results of Zalando may have negatively affected the expectations of the investors (negative results imply no dividends distribution) even though it experienced positive quarterly results prior to its IPO.

Also, this worrisome trend persisted during the next two months until the 25th of November: the price finally started to „skyrocket” almost reaching the cap of 25€ and stayed more or less constant over the remaining period.

On the other hand, Rocket Internet followed the same process: it first announced to price its shares on a price range of 35,5€ to 42,5€ before finally pricing them on the upper side at 42,5€.

graphil2
Graph 1.2

This time, a different tendency is observed. Indeed, even though the IPO’s results were also disappointing, the shares price „recovered” relatively faster than Zalando’s to reach their issue price. At the end of October, the price already stood over 42,5€ and stayed constantly above it reaching some days peaks of 52€ the 10th of November, for instance (representing an increase of 22,3% compared to issue price). Unlike Zalando’s share, Rocket Internet ones are much more volatile over the period analyzed.

Graph 1.3
Graph 1.3

During IPOs in general, we all probably hear about the media explaining us that a particular share disappoints because its price shrink or that another is very performing because it increases. But these statements are not really correct. Indeed, from an economic point of view, an IPO is successful when its share price does not change or at least, does not fluctuate heavily. If the price is too high, no investors are going to buy the shares. And on the opposite, if the price is too low (underpriced IPO), money if left on the table even if the market cap of the company increases. In the case of Rocket Internet, the company is clearly not underpricing. But for Zalando, it can be seen that at the end of the first day of trading, the share price actually increases (before eventually plummeting). So technically speaking , Zalando underpriced its shares but not for long.

In the history of companies’ IPOs, a lot of companies have been heavily underpricing their shares, leaving a lot of money on the table. This has caused huge increases in share price in the first day of trading. Baidu.com, a Chinese version of Google made a historic IPO leading to an increase of 354% of its share price at the end of the trading day, the „biggest” IPO since 2000. If we go even further back in time, ridiculous increases of 627% of LINUX shares can be observed in 1999.

As explained above, Rocket Internet shares „recovered” earlier and increased by a higher rate than Zalando’s. But what are the potential reasons of these differences? One potential possible explanation can come from the fact that investors have more trust on Rocket Internet because it is basically the founder of Zalando.

This leads us to a fundamental question that remains unanswered: what moves the price of the stock market? No one knows it for certain. What builds the financial market in the world of today is confidence. This element might be the most important in today’s economics. If companies cannot convince investors, they are doomed to failure. So, information plays a key role and it definitely moves the stock market.

Nevertheless, there are still some factors that influence market variations. We are going to quickly go through these factors. They can be distinguished into three different categories:

  1. Internal factors: all the factors within companies that directly affect stock fluctuation like M&A, dividends distribution, changes in management, etc.
  2. External factors: these factors regroup all kind of events and changes, economic or not, that affect stock price like changes in inflation, interest rate, general economic context, demographics, world events, etc. For instance, there were some threats on stock price because of the recent events in Russia and Ukraine.
  3. Sentiment/”hype” factors: more and more attention is being given to these factors. They regroup different type of factor like the overall market’s sentiment (how do investors feel about a certain company) or the hype on a company’s new product. But they can also be more general. A lot of interesting studies have been made about the different characteristics that can affect investor’s decision making: gender, IQ, mood, weather, etc. At the end of the day, there is not really a clear equation or model to predict how to price are going to move in the stock market. Uncertainty is the watchword of stock markets movement.

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