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This paper is based on Moonchul Kim's University of Illinois Ph.D. dissertation. We would like
to thank seminar participants at Boston, Emory, Georgetown, Humboldt (Berlin), and Vanderbilt
Universities, the Universities of Miami and Texas, the Stockholm School of Economics, the Chinese
University of Hong Kong, the New York Federal Reserve, the National Bureau of Economic
Research, the 1996 Harvard Financial Decisions and Control Workshop, the 1997 Tuck Underwriting
Conference, and Alan Eberhart, Chris Barry, Harry DeAngelo, Linda DeAngelo, Craig Dunbar, John
Fellingham, Kathleen Weiss Hanley, Chris James, Linda Killian, Inmoo Lee, Joshua Lerner, Tim
Loughran, Michael Ryngaert, Bill Schwert (the editor), Theodore Sougiannis and David Ziebart for
numerous comments. We would like especially to thank an anonymous referee for constructive
suggestions. We would like to thank Sophia Chiang, Linda Killian, and Joshua Lerner for generously
providing data. The assistance of Hsuan-Chi Chen and Inmoo Lee is particularly appreciated.
Journal of Financial Economics 53 (1999) 409}437
Valuing IPOs
#a
(P/E)
G
#e
G
, (1)
where (P/E)
G
"the median price/earnings ratio, using the most recent 12
months of pre-IPO earnings for comparable IPOs and the most recent four
quarters of earnings for the research boutique's comparables. When we use
market-to-book ratios,
M/B
'''''"G
"a
#a
(M/B)
G
#e
G
, (2)
where (M/B)
G
"the median M/B ratio, using the postissue book value of
equity for comparable IPOs. The research boutique does not use market-to-
book ratios. It does, however, use price-to-sales ratios, which we implement in
the following way:
P/S
G
"a
#a
(P/S)
G
#e
G
, (3)
where sales are the trailing 12-month sales, as reported in the preliminary
prospectus for the IPOs and as reported in the most recent "nancial statements
for the other comparable "rms. In Eqs. (1)}(3), we calculate the market multiples
for the comparable "rms using the closing market prices on the day prior to the
o!er date.
The null hypothesis in Eqs. (1)}(3) is that a
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420 M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437
Table 3
Distribution of multiples for IPOs from 1992 to 1993 and their comparable "rms using recent IPOs,
and prediction errors
IPOs and their comparable "rms are restricted to "rms with positive preissue book value of equity
and positive earnings, where earnings are measured for the most recent 12 months prior to going
public. There are 190 IPOs with at least one prior IPO (on the "ling date) in the same four-digit SIC
code with positive EPS during the 12 months before it went public to use as a comparable. If there
are more than "ve qualifying IPOs to use as comparables, we use the "ve IPOs with the closest sales.
Price}earnings (P/E), postissue market-to-book (M/B), and price-sales (P/S) ratios are calculated
using the o!er price for the IPOs, and the market prices on the day before issuing for the comparable
"rms. In calculating the median P/E, M/B, and P/S ratios for the comparable "rms, if there is an
even number of "rms, we use the midpoint of the adjacent ratios. All M/B and P/S ratios above 10
are set equal to 10 and all P/E ratios above 100 are set equal to 100. The means of the IPO
distributions are lower than those reported in Panel B of Table 1 because the means in this table are
computed after the aforementioned adjustments of extreme values have occurred. The prediction
error is measured as the natural logarithm of the median comparables multiple minus the natural
logarithm of the IPO multiple. The absolute prediction error is the absolute value of the prediction
error. The percentage of predicted valuations within 15% of the actual multiple is computed as
"log(predicted)!log (actual)"(0.15. For these last calculations, the IPO multiples are calculated
using both the o!er price (OP) and the "rst closing market price (P
'''
).
Panel A: Distribution of multiples
IPOs Comparable "rms medians
Mean Percentile of distribution Mean Percentile of distribution
25th 50th 75th 25th 50th 75th
P/E 32.6 15.3 24.0 42.5 39.9 20.1 31.6 55.6
M/B 3.3 2.3 3.0 4.0 4.6 2.7 4.0 5.8
P/S 2.7 1.2 2.1 3.6 3.2 1.5 2.7 4.1
Panel B: Prediction errors
Prediction error Absolute prediction error Percentage of
predicted valuations
within 15% of actual
multiple using
Mean (%) Median (%) Mean (%) Median (%) OP (%) P
'''
(%)
P/E 21.7 32.8 68.6 55.9 12.1 11.1
M/B 26.2 26.4 50.3 41.2 21.6 21.6
P/S 16.3 10.5 69.4 51.2 16.2 12.0
M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437 421
Table 4
OLS regressions with IPO multiples as the dependent variables using comparable "rm multiples as
explanatory variables
The sample contains 190 IPOs from 1992}1993 with at least one IPO from the previous 12 months
in the same (four-digit SIC) industry and meeting the selection criteria listed in Table 1. The median
price/earnings (P/E), price/sales (P/S), and postissue market-to-book (M/B) ratios of other IPOs in
the same industry that went public during the prior 12 months are used for issuing "rm i. No more
than "ve "rms are used to calculate the median; if more than "ve recent IPOs qualify, we use the "ve
"rms with the closest 12-month revenues as the comparables. For both the issuer and the compara-
ble "rms, earnings per share is de"ned as the EPS in the 12 months prior to going public, and book
value per share is de"ned as the postissue BPS. For the percentage of valuations within 15% of the
actual multiples, OP is the o!er price and P
'''
is the "rst closing market price. The prediction
errors are measured as the natural log of the ratio of the predicted multiple to the actual multiple,
using the regression for the prediction; t-statistics are in parentheses.
P/E
G
"a
#a
P/E
G
#e
G
M/B
G
"a
#a
M/B
G
#e
G
P/S
G
"a
#a
P/S
G
#e
G
Dependent
Variable
Coe$cient
estimates
R
(%)
Absolute prediction errors Percentage within 15%
of actual multiple using
a
/(1#
/
`
), where
#a
P/E
G
#e
G
P/E
Calculated
using
Parameter
estimates
R
(%)
Absolute
prediction error
Percentage
within 15%
N
Intercept P/E Mean
(%)
Median
(%)
Regression
(%)
Simple
(%)
(1) POP 25.47 0.126 2.1% 51.2% 43.6% 14.7% 12.6% 190
(9.32) (2.24)
(2) OP 24.07 0.216 5.0% 56.5% 49.9% 14.2% 17.4% 190
(7.79) (3.30)
(3) P
'''
28.09 0.252 4.8% 64.2% 58.0% 10.5% 12.6% 190
(7.66) (3.24)
lists the &street' estimate (i.e., the consensus earnings forecast) for current "scal
year and next year EPS, as well as the latest 12 months' EPS numbers, for the
IPO and two comparable "rms. These research reports are typically produced
immediately after the preliminary prospectus is issued and faxed to clients.
426 M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437
Renaissance Capital uses this information to calculate three P/E ratios (using
the midpoint of the preliminary o!er price range (POP) for the IPO) using the
last 12 months, current "scal year's forecast, and next year's forecast, of EPS.
Renaissance Capital also calculates these three P/E ratios for each of the two
comparable "rms, using the closing market price of the stock on the day before
the report is issued.
Frequently, Renaissance Capital chooses its comparables based upon "rms
mentioned in the prospectus as the major competitors of the "rm going public.
In choosing comparable "rms, Renaissance Capital does not restrict itself to
companies with the same SIC codes. For example, for the November 1993 IPO
of Gateway 2000 (a direct marketer of PCs assembled from purchased compo-
nents), it chose Dell Computer (another direct marketer of PCs) and AST
Research (a PC manufacturer, although not a direct marketer). Gateway 2000
had an SIC code of 596 (nonstore retailers), while both Dell Computer and AST
Research have SIC codes of 357 (o$ce and computing machines manufactur-
ing). All three "rms had 12-month sales of $1.5 to $2.6 billion.
To examine whether our valuation accuracy can be improved by incorporat-
ing better comparables, earnings forecasts, and adjustments re#ecting di!er-
ences in pro"tability and growth, we use a subsample of 143 IPOs from
September 1992 to December 1993 for which evaluations are available from
Renaissance Capital, and for which we have comparable "rm multiples for other
"rms in the industry from Compustat. We start in September 1992 because
Renaissance Capital did not begin operations until mid-1992. During this
sample period, the Dow Jones average was below 4000. Since we exclude IPOs
with negative trailing earnings, negative pre-issue book value, or small expected
market capitalization, or where there are no Compustat-listed "rms in the same
industry, this sample is tilted towards IPOs for which the comparable "rms
methodology should work best.
5.2. Valuations using forecasted earnings, and for young and old xrms
While historical earnings contained in the prospectus are available to all
market participants, practitioners also frequently use earnings forecasts for
valuation purposes. To examine the degree to which forecasted earnings, on
both the IPOs and their comparables, can be used for valuation purposes, in
Table 6 we use the geometric mean of the Renaissance Capital comparable "rm
P/E multiples as the explanatory variable in regressions using the three P/E
ratios of the IPOs as dependent variables. When one of the comparable "rms
has a negative EPS, we use the other comparable's P/E ratio exclusively. We
constrain all IPO and comparable "rm midpoint P/E ratios to be no greater
than 100. The geometric mean of, for example, ratios of 4 and 46 is the square
root of the product of 4 times 46, or 13.56. The geometric mean is used because it
puts less weight on extreme values than using the midpoint of two ratios.
M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437 427
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M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437 429
Comparing the regressions using, respectively, historical earnings, the current
year's forecasted earnings, and the next year's forecasted earnings, the average
absolute prediction errors fall from 55.0% to 43.7% to only 28.5%, and the
percentage of "rms that are valued within 15% of the actual multiple increases.
Thus, as expected for these predominately young "rms, forecasted earnings
work better than historical earnings. It should be noted, however, that the
&street' earnings forecasts for the IPOs are typically provided by analysts who
are a$liated with investment bankers, so there may be a con#ict of interest.
Nonetheless, the slope coe$cients, while signi"cantly above zero, are all signi"-
cantly below 1.0, the value that would be predicted if the implementation of the
comparable "rms approach worked perfectly.
For comparison, we also report regression results using the median P/E ratio
of comparable "rms in the same industry listed on Compustat for the 143 IPOs
in this subsample. The Renaissance Capital comparables do a slightly better job
at explaining the cross-sectional dispersion of IPO P/E ratios than comparables
chosen using SIC codes do. This suggests that the main source of better
predictions is from using earnings forecasts, rather than from picking more
appropriate comparable "rms.
One reason that the Rs are below 100% and the slope coe$cients are below
1.0 in Table 6 is that the comparable "rms have di!erent growth rates than the
IPOs. The standard growing perpetuity valuation model (assuming a 100%
payout rate),
P
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where r is the required return and g is the growth rate of earnings, would predict
that "rms with more rapid growth rates should have higher P/E ratios. In Rows
(5)}(7) of Table 6, we add a dummy variable, which takes on the value 1 if the
sales growth rate of the IPO is higher than the midpoint of the sales growth rates
of the comparable "rms. The prediction is that this dummy variable should be
positive if the earnings of fast-growing "rms are capitalized at higher multiples.
Inspection of these three rows shows that this dummy variable has the predicted
sign, but is not signi"cant at conventional levels. Alternative speci"cations, such
as the di!erence in logarithms of the sales growth rates, or using an interactive
term in which the dummy variable is multiplied by the comparables' P/E, yield
qualitatively similar results. One possible reason that di!erences in growth rates
have such modest explanatory power is that the rapidly growing "rms going
public may be viewed by the market as having a higher transitory component in
their earnings. In other words, a lower &quality' of earnings may partly o!set
di!erences in growth rates.
In Rows (8) and (9), we segment the sample on the basis of the age of the issuer
at the time of its IPO. The presumption is that older "rms will be easier to value,
430 M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437
since more of their value is represented by capitalized earnings than by expecta-
tions about future growth rates, which can vary substantially from "rm to "rm.
Consistent with this presumption, the mean absolute prediction error for "rms
that are less than ten years old at the time they go public is higher than that for
older "rms: 31.9% for young "rms in Row (8), versus 23.0% for older "rms in
Row (9).
5.3. Valuations using multiples that are invariant to leverage
Renaissance Capital does not use M/B ratios in its comparable "rms analysis.
Linda Killian, a co-founder of the "rm, told us that they feel that the arbitrari-
ness of book values (and the large change from before the issue to after) makes
M/B ratios poor valuation metrics. Renaissance Capital does, however, calcu-
late several other multiples, including price-to-sales and enterprise value to
operating cash #ow, where enterprise value"market value of equity#book
value of debt!cash. Enterprise value is analogous to total "rm value, but is
neutral with respect to the cash raised in an equity o!ering. The proceeds of an
equity o!ering would boost the market value of equity, but if the proceeds are
retained as cash, these two e!ects cancel each other out. Operating cash #ow
(also known as EBITDA, earnings before interest, taxes, depreciation and
amortization) is not a!ected by leverage, so enterprise value/operating cash #ow
permits comparisons between "rms with di!erent degrees of leverage. Using
the enterprise value that Renaissance Capital computes, we also compute the
ratio of enterprise value-to-sales, using the last twelve month sales. In making
these computations, we calculate the market value of equity for the "rm going
public using the midpoint of the "le price range, and other pro forma (as adjusted
for the proceeds of the o!ering) values are used. Comparable "rms' values
are computed using accounting information and the market price at the time
the IPO is valued (immediately after the dissemination of the preliminary
prospectus).
In Table 7, we report regression results using market value-to-sales, enterprise
value-to-sales, and enterprise value-to-operating cash #ow ratios. The depen-
dent variable is the ratio for the IPOs, and the chief explanatory variable is the
geometric mean of the ratios for the two comparable "rms used by Renaissance
Capital. As in Table 6, we report regression results for the entire sample of 143
IPOs covered by Renaissance Capital and, in some speci"cations, we include
a dummy variable taking on the value of one if the sales of the IPO are growing
faster than the midpoint of the comparable "rms' growth rates, interacted with
the comparable "rm multiple. The advantage of this interactive approach is that
the slope coe$cient can be interpreted as a percentage shift (after multiplying by
100%). With an additive term, as we use in Table 6, we are implicitly assuming
that the absolute increase in a multiple should be as large for a "rm in an
industry with low multiples as in an industry with high multiples.
M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437 431
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Using price-to-sales ratios, Panel A of Table 7 shows that the average
absolute prediction error is of the same order of magnitude as when historical
earnings were used in Table 6. When the dependent variable is changed to
deleverage "rms (enterprise value-to-sales) in Panel B, the average absolute
prediction errors drops a bit. In Panel C, where enterprise value-to-operating
cash #ow ratios are used, the valuation accuracy improves to about the same
level as when P/E ratios using current year earnings forecasts are used. Not
surprisingly, the enterprise value-to-operating cash #ow ratio works substan-
tially better for older than younger "rms.
Finally, using enterprise value-to-sales ratios, in Table 8 we report regression
results that adjust for di!erences in cash #ow per dollar of sales as well as growth
rates, with both of these variables interacted with the comparable "rms multiple.
As a measure of di!erences in pro"tability, we use the logarithm of the ratio of
operating cash #ow per dollar of sales for the IPO relative to its comparable
"rms, interacted with the enterprise value-to-sales multiple. In Row (2), the
coe$cient of 0.218, with an associated t-statistic of 4.18, indicates that adjusting
for di!ering levels of pro"tability is important. This coe$cient suggests that
a 20% premium for "rms that are twice as pro"table as average is warranted.
The sales growth rate dummy variable, interacted with the enterprise value-to-
sales multiple, has a coe$cient of 0.199. This suggests that a 20% premium for
fast-growing "rms going public is also warranted. These results are consistent
with industry practice of starting with comparable "rm multiples and adding (or
subtracting) 10}20% adjustments for di!erences in pro"tability or di!erences in
growth. When we split the IPOs into young and old "rms, we achieve greater
valuation accuracy for older "rms. Not surprisingly, for older "rms pro"tability
di!erences are very important and sales growth rate di!erences are unimpor-
tant. Still, the valuation accuracy as measured by average absolute prediction
errors is not as good as when the next year's earnings forecasts are used in
Table 6.
As yet another measure of the valuation accuracy implied by our regression
results, equation of Table 8 can be used to predict an enterprise value-to-sales
ratio for each IPO. We can then use this ratio to come up with a predicted o!er
price, which can be compared with the actual "rst closing market price. Doing
this, in unreported calculations, the median absolute prediction error, calculated
as "P
'''
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prediction error of $2.50 between the market price and the midpoint of the "le
price range, and a median absolute prediction error of $1.50 between the market
price and the "nal o!er price. These numbers are consistent with our assertion
that investment bankers add value in pricing new issues. (All three of the above
numbers change by no more than a dime if an adjustment is made to account for
the short-run underpricing phenomenon.)
434 M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437
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M. Kim, J.R. Ritter / Journal of Financial Economics 53 (1999) 409}437 435
6. Conclusions
This paper examines the pricing of IPOs using comparable "rm multiples,
a procedure that is widely recommended by academics and practitioners and is
standard practice in IPO valuation case studies used in business schools. We
"nd that valuing IPOs on the basis of the price-to-earnings, price-to-sales,
enterprise value-to-sales, and enterprise value-to-operating cash #ow ratios of
comparable "rms is of only limited use if historical numbers rather than
forecasts are used. Within an industry, the variation in these ratios is so large,
both for public "rms and IPOs, that they have only modest predictive value.
Many idiosyncratic factors are not captured by industry multiples unless vari-
ous adjustments for di!erences in growth and pro"tability are made. Using
earnings forecasts improves the valuation accuracy substantially. The valuation
accuracy is higher for older "rms than for young "rms.
Using historical accounting information and controlling for leverage e!ects,
the enterprise value-to-sales ratio works reasonably well for both young and old
"rms. Additional adjustments that re#ect di!erences in sales growth rates and
di!erences in pro"tability per dollar of sales improve the "ts even more. This is
consistent with the industry practice of starting with an industry multiple and
adding or subtracting adjustments of 10}20% to re#ect di!erences in growth
rates, pro"tability, quality of earnings, etc.
The di$culty of using comparable "rm multiples for valuing IPOs, without
further adjustments, leaves a large role for investment bankers in valuing IPOs.
Because using the midpoint of the o!er price range results in smaller prediction
errors than using comparables, investment bankers apparently are able to do
superior fundamental analysis. In addition, investment bankers are able to
achieve additional valuation accuracy by canvassing market demand before
setting a "nal o!er price. While much attention has been focused on the wide
variation between the o!er price and subsequent market prices that occurs in
practice, our results suggest that the pricing precision would be much worse if
a mechanical algorithm was used instead.
Finally, we should note that in this paper we use the same multiples for all
industries. In practice, analysts place more weight on a given multiple for some
industries than others. Taking this into account would probably show that compa-
rable "rm multiples result in more accurate valuations than our work suggests.
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