When a private company decides to go public via an initial public offering, often shortened to "IPO," the existing private shareholders and potential public shareholders must estimate what each thinks the company's price should be.

One of the most common techniques to do this is the prospectus price-to-earnings ratio, or the P/E ratio.

Buyers versus sellers at the IPO
The IPO process is a quintessential buyer and seller market interaction.

The existing private shareholders are trying to raise as much money as they can maximize both the new capital for the company and the value of their existing shares. They're selling, and they want to sell high.

Potential new investors, on the other hand, are looking to get a good deal. These public investors won't just pay any price, the price must make sense in relation to the company's fundamentals and future prospects. They're the buyer, after all.

So how do these two interests determine how much a share is worth before the IPO? Ultimately they buy and sell the stock on the public market, creating an equilibrium between the bid and the ask. But even before the stock reaches the public market, both sides use very similar methods to estimate the appropriate price. Perhaps the most common valuation metric, and one of the simplest, is the P/E ratio.

The price-to-earnings ratio for IPOs
To calculate the-price-to earnings ratio, divide the company's price per share by its earnings per share. Some analysts use the company's most recent earnings per share. Others use a projected earnings per share for the next year. Others use a trailing-12-month calculation. Any of these methods will work, as long as the same method is used when comparing the company to its peers.

In the case of an IPO, there is no precise valuation yet -- we are going to estimate a possible range for it in this exercise -- but we do have the company's earnings and share information to calculate earnings per share. Both of these figures are available on the prospectus document filed with the SEC as part of the IPO process. We can also estimate what we think the company's P/E ratio could be based on the ratios of its publicly traded competitors.

Doing a little algebra, we can rearrange the P/E ratio formula to solve for the price per share, instead of the P/E ratio itself. Doing this, we can calculate the price per share by multiplying its earnings per share by the comparable P/E ratios of the company's peers.

There is a bit of art involved in this estimation. No two companies are exactly the same, and the company about to IPO may trade at a higher or lower multiple than their competitors even if they are fairly similar. This variation depends on any number of different factors -- growth rates, the business mix, their balance sheet composition, their margins, and many others. That's why it's important to look at several competitors to get a feel for the full range of possible P/E ratios.

An example of estimating an appropriate prospectus P/E ratio
Let's consider the following hypothetical example. In the real world, there would be far more factors to review, but for simplicity we'll just include each company's growth rate to illustrate the process. We'll assume that shares outstanding are comparable between all four companies so that earnings per share can be compared directly.

 

P/E Ratio

Earnings per share

Growth rate

Prospectus Company

???

$0.50

10%

Competitor 1

15

$5.00

3%

Competitor 2

18

$0.75

15%

Competitor 3

10

($1.25)

(1%)

In this example, the Prospectus Company has a strong growth rate, far higher than Competitors 1 and 3, but 50% less than Competitor 2. The Prospectus Company has much lower earnings than Competitor 2 but is considerably more profitable than Competitor 3. Competitor 2 has slightly better earnings, but not outrageously so.

In terms of the P/E ratios of the competitors, Competitor 2 trades at the highest multiple, implying that the market values its exceptional growth rate more than its lower earnings per share. Competitor 1 trades at a slightly lower multiple to Competitor 2, indicating that even without exceptional growth, its best-in-class profitability is still valued by the market. Competitor 3 trades at a large discount to the other two competitors thanks to its negative growth and earnings per share.

The market should value the Prospecuts Company's strong growth, but that will be offset somewhat by its lower profitability. It's unlikely to trade at 18 or higher because its growth and profitability are less than Competitor 2. It's unclear though how the market will compare the Prospectus Company to Competitor 1 given the dramatically different growth rates and earnings per share.

Based on this, it seems reasonable to expect our Prospectus Company to trade with a P/E ratio somewhere in the range of 14 to 17.

It's all about the market
The market will ultimately decide the appropriate P/E ratio once the stock is actively traded on the public markets. The prospectus price-to-earnings ratio is merely a tool to estimate what that ultimate valuation could be before a private company completes its IPO.

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