SME IPO Valuation

The IPO valuation determines the fair market value of a company’s shares before they are offered to the public. This valuation for the IPO of SMEs determines the price at which the shares will be sold during the IPO. An accurate valuation is crucial as it affects the company's ability to raise capital and influences investor perception.

Merchant bankers play a crucial role in the valuation of IPOs by assisting the issuing company in the valuation process.

For SMEs, this involves assessing financial performance, assets, market position and growth potential.

Given the fluctuating cash flows and limited resources of SMEs, these factors must be carefully considered for an accurate valuation. Let’s discuss in detail the factors that affect the valuation of SME IPOs .

Factors Impacting SME IPO Valuation

1. Business Segment
   • Market Segment : The business segment in which an SME operates has a significant impact on its valuation. Companies in high-growth or high-demand sectors are generally valued higher.
   • Sector Trends : Current trends within the business segment, such as technological advances or regulatory changes, also play a decisive role in the valuation of the IPO.
2. Size of the Business
   • Market Share: Larger SMEs with a significant market share and operational size tend to be valued higher.
   • Revenue and Assets : The total size of revenue, the asset base and the geographical reach lead to a positive valuation.
3. Profitability of the Company
   • Profit Margins : High gross and net profit margins indicate efficient management and operational effectiveness, which increases valuation.
   • Cash Flow : Consistent and strong cash flow is a sign of financial stability and health.
4. Previous Track Record & Future Potential
   • Financial Track Record : A strong financial track record, marked by continuous growth in revenues and profits, is crucial for the valuation of an IPO.
   • Growth potential : Future expansion plans and the ability to scale the business have a significant impact on the valuation. Companies with clear and achievable growth prospects are valued higher.
5. Demand
   • Stock Demand : High demand for a share generally drives up its price. The willingness of investors to invest a lot can increase the valuation. However, high demand alone is not a sufficient indicator of value. One needs to assess the demand correctly.
6. Management Team Background
   • Expertise : The background and experience of the management team are crucial. Experienced and competent leaders strengthen investor confidence and the valuation of the company.
   • Track Record : A strong track record of management in successfully overcoming challenges has a positive impact on valuation.
7. Economic Scenario and Market Fluctuations
   • Market Conditions : The prevailing economic conditions (local and global) at the time of the IPO have a significant impact on valuation. A robust economy generally leads to higher valuation multiples.
   • Market Sentiment : Investor sentiment and market trends during the IPO period also play a crucial role. Positive market conditions have a positive impact on valuation, while a downward trend may not attract investors despite strong fundamentals.
8. Peer Comparison
   • Industry Comparison : The valuation of an SME is often compared with the valuation of other companies in the same industry. A significant deviation in valuations can deter investor interest.
   • Market Prices : Reviewing market prices and valuations of similar companies helps determine a realistic and competitive valuation.
9. Products and Services
   • Market Need : Companies that offer products and services that meet essential needs or significantly improve the quality of life are valued more highly.
   • Innovation : Innovative and unique product offerings also increase the attractiveness of the IPO.

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SME IPO Valuation Process

Merchant bankers have the knowledge and experience to understand and analyze all the factors that impact IPO valuation . To derive the valuation of a company, a merchant banker proceeds as follows:

1. Gather all previous data and details about the company, including its financials.
2. Analyze the collected data to understand the financial health and performance of the company.
3. Ensure that the data is audited for accuracy and reliability.
4. Map the competitive valuations by comparing them to similar companies in the industry.
5. Examine all factors that affect the valuation , such as market conditions, the economic environment and the company’s growth potential.
6. Apply one or more IPO valuation techniques , such as Discounted Cash Flow (DCF), Net Worth Valuation or Relative Valuation, to derive the valuation of the company.
7. Include all relevant information and valuation details in the draft document.
8. Submit the draft document and data to SEBI for analysis and approval.

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SME IPO Valuation Methods

The result of the valuation determines the overall value of the company and the price at which it can raise funds from the market through a stock market listing. There are various methods for calculating IPO valuations. Some IPO valuations are based on purely mathematical calculations, while others are based on relative approaches, experience and assumptions.

1. Valuations based on identical transactions in the market (Relative valuation)

The relative valuation method is also known as the comparative valuation method. In this method, the valuer identifies the most recent transactions in the market for companies in a similar industry. Based on these transactions, a reference multiple is calculated with appropriate adjustments to determine the value of the company.

Merchant bankers use this method to compare the key performance ratios of similar listed companies in the industry to determine the value that investors are willing to pay. These comparisons include ratios relating to:

• Revenue
• Earnings
• Market capitalization

Steps in the Relative Valuation Method:

The relative valuation method involves a simple 4-step process that requires strong analytical skills and market knowledge:

1. Identify similar companies.
2. Determine valuation multiples such as the price-to-earnings ratio (PE), enterprise value (EV), earnings per share ( EPS ), earnings before interest and taxes ( EBIT ), and more.
3. Compare values.
4. Determine the value of the issuing company after adjusting for factors such as strength, risks, and growth potential, which may vary for each company.

Let's take a simple example to understand the above concept of relative valuation using the price-earnings multiple, which evaluates the rough valuation of the company based on its EBIT (Earnings Before Interest and Taxes).

Example : You want to assess the valuation of your business that is in the IT sector. As a first step, check for the PE ratio of the IT services industry from eqvista OR Getmoneyrich.com . Say the PE ratio of the IT sector is 24.0642%.

Let us assume that the EBIT (Earnings Before Interest and Tax) for your company is Rs 27.54 crores. Because your company is new, it is better to take half of the IT PE ratio or less than that and check for a range of PE to get a fair idea of the valuation of your company. We assume a P/E ratio of 15-20% and use the formula below to determine a rough value for your company.

PE Multiple Valuation = PE Multiple * EBIT

Note: Use our Business Valuation Calculator for more details.

Considering the above formula, the company's valuation ranges from around Rs. 413 crores to Rs. 550 crores.

2. Valuation based on the Discounted cash flows (DCF) (Absolute Valuation Method)

The absolute valuation method determines a company's intrinsic value based on its future cash flows without comparing it with other companies. The DCF method is a type of the absolute valuation method. It estimates the value of a company by discounting the expected future cash flows to the present value.

It projects free cash flows for a certain period, discounts them using a discount rate often referred to as WACC (Weighted average cost of capital), and adds the terminal value to determine the present value of the company.

Steps to value a company using the absolute valuation approach:

• Determine a time period and complete the cash flow projection for that period.
• Derive the WACC. This denotes an investor's expected rate of return. The WACC is used as a discount rate.
• Calculate the present values of the cash flows for each year by dividing the projected cash flow by 1 plus the discount rate raised to the power of the year i..e 1 for Year 1, 2 for year 2 and so on.

For example, the projected cash flow for the first year is 1/(1+ discount rate)1

• Add up all the projected cash flows derived for each year according to the formula above.
• Derive the terminal value.
• Add the terminal value to the discounted cash flow of all years to obtain the present value of the business.

Example

• Profit After Tax (PAT) Last FY : 15 crores
• Cash Profit : 85 crores
• Growth Expectations : 20%
• Discounting Rate : 15%
• PE Multiple : 10 times
• Terminal Value : 5%

Discounted Cash Flow Year (n) = Cash Flows Year (n) × Discounting Factor Year (n)

Discounted Cash Flow Year (n) = 15.30×0.87=13.31 crore

Repeat for subsequent years.

Terminal Value:

Terminal Value = PAT (Year 5) × (1+Terminal Value Growth Rate) / Discounting Rate - Terminal Value Growth Rate * Discounting Factor (Year 5)

Terminal Value = (37.32 × (1 + 0.05) / 0.15 - 0.05) * 0.50 = 166.53 crore

The absolute value of a business assuming cash flows for 5 years

= Cash Flow for Year 1/(1+WACC)1 + Cash flow for Year 2/ (1+ WACC)2+ Cash Flow for Year 3/(1+WACC)3+………………+ Cash flow for Year 5/(1+WACC)5+ Terminal Value /(1+WACC) last year of projection = 239.26 crore

Total Valuation Based on DCF

• Sum of Discounted Cash Flows : 13.31 + 13.95 + 14.54 + 15.07 + 15.86 = 72.73 crore
• Terminal Value : 166.53 crore
• Total Valuation (DCF) : 72.73 + 166.53 = 239.26 crore

Summary

The DCF method calculates the present value of projected cash flows and the terminal value. In this case, the discounted cash flows for five years and the terminal value were calculated using a discounting rate of 15%. The sum of these values gives an overall valuation of the company based on the DCF method of Rs.239.26 crore.

Note: In India, only a Category 1 merchant banker registered with SEBI can carry out share valuation for income tax purposes. This is required when a company issues new shares or transfers shares, and when the valuation is done using the Discounted Cash Flow (DCF) method.

3. Valuation based on earnings or book value multiple

This valuation method determines the earnings per share (EPS) and/or the book value per share of the company. The calculated earnings or book value is then multiplied by an appropriate multiple derived from the prevailing price/earnings ratio ( P/E ) or price/book ratio in the market for similar companies in the same industry.

Key Steps in the Process:

1. Determine EPS and Book Value Per Share
   • Earnings Per Share (EPS) : This figure is calculated by dividing the company's net profit by the number of outstanding shares. It indicates the profitability of the company on a per-share basis.
   • Book Value Per Share : It is calculated by dividing the total net assets of the company (assets minus liabilities) by the number of outstanding shares. It represents the per-share value of the company's net assets.
2. Select a Suitable Multiple Factor
   • P/E Ratio : This is the ratio of a company's current share price to its earnings per share. A higher P/E ratio might indicate that the market expects higher growth in the future.
   • Price-to-Book Ratio : This ratio compares the market value of the company with its book value. A higher ratio may indicate that the market expects high growth or that the company's assets on its balance sheet are undervalued.
3. Apply the Multiple Factor
   • Multiply the EPS by the P/E ratio to estimate the company's value based on earnings.
   • Multiply the book value per share by the price-to-book ratio to estimate the company's value based on its net assets.

Example Calculation:

1. Determine EPS
   • Suppose a company has a net profit of Rs. 10 crores and 1 crore outstanding shares. The EPS would be Rs. 10 (10 crores / 1 crore shares).
2. Determine Book Value Per Share
   • If the company’s total net assets are Rs. 100 crores and there are 1 crore shares outstanding, the book value per share would be Rs. 100 (100 crores / 1 crore shares).
3. Select Multiples
   • Assume the P/E ratio for similar companies in the industry is 15.
   • The price-to-book ratio for similar companies is 2.
4. Apply Multiples
   • Earnings-Based Valuation: Rs. 10 (EPS) * 15 (P/E ratio) = Rs. 150 per share.
   • Book Value-Based Valuation: Rs. 100 (book value per share) * 2 (price-to-book ratio) = Rs. 200 per share.

4. Valuation based on the Net worth of the Company

Valuing a company based on its net worth is one of the simplest and most traditional methods. This approach focuses on the company's equity and accumulated reserves at the balance sheet date. The net value of a company is essentially the total value of its equity plus its accumulated reserves. It reflects the total net value of the investments made in the company by its shareholders. In other words, the net worth represents the book value of the company.

Here are the most important points to consider:

• Equity : The total amount that shareholders have invested in the company.
• Accumulated reserves : Profits that remain in the company and are not distributed as dividends.
• Book value : The net value corresponds to the book value of the company, i.e. the value recorded in the company's financial statements.

Example:

Let’s assume Company A has the following on its balance sheet as of March 31, 2025:

• Share Capital (Equity): Rs 10 crore
• Accumulated Reserves: Rs 15 crore

Net Worth = Share Capital + Accumulated Reserves = Rs 10 crore + Rs 15 crore = Rs 25 crore

Thus, the valuation of Company A based on its net worth method would be Rs 25 crore.

5. Economic Valuation Method

The economic valuation method is a purely mathematical, formula-based approach to determining the value of a company based on its financial and economic factors. This method relies on quantifiable data such as debt, market capitalisation, income, assets, and other economic indicators, without involving comparisons or assumptions as in relative or absolute valuation methods.

Steps for Economic Valuation Method:

1. Determine Enterprise Value (EV) : Calculate the company's total market value, including equity, debt, and other interests.
2. Add Cash and Cash Equivalents : Include all liquid assets that can be quickly converted to cash.
3. Subtract Value of Debt and Other Liabilities : Deduct the total value of all debts and other financial obligations from the sum of EV and cash equivalents.

Formula for IPO Valuation Using the Economic Valuation Approach

IPO Valuation= EV + Cash and Cash Equivalents - Value of Debt and Other Liabilities

Example Calculation

Let's consider a hypothetical company with the following financial data:

• Enterprise Value (EV) : ₹500 crore
• Cash and Cash Equivalents : ₹50 crore
• Value of Debt and Other Liabilities : ₹200 crore

Using the economic valuation formula, the IPO valuation would be calculated as follows:

IPO Valuation = EV + Cash and Cash Equivalents − Value of Debt and Other Liabilities

Substituting the given values:

IPO Valuation= Rs 500 crore + Rs 50 crore − Rs 200 crore

IPO Valuation= Rs 350 crore

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Choosing the right valuation method for SME IPO

For instance, during a recession, the relative valuation method may not be the most effective. The overall market downturn would impact all companies, making comparisons less meaningful and potentially undervaluing the IPO. Additionally, finding suitable comparables may be challenging. In such scenarios, merchant bankers might prefer economic or absolute valuation methods.

In situations where predicting future earnings is difficult, other valuation methods are considered more appropriate over discounted cash flow methods. Each method requires specialized skills and in-depth knowledge, often necessitating the involvement of third-party valuers. Merchant bankers charge fees ranging from Rs 3 lakhs to Rs 8 lakhs for the valuation of shares, depending on the issue's size and the business's complexity.