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Initial public offerings that are graded higher have better price-to-earnings ratio, says a report from Crisil.
A study conducted on 117 initial public offerings graded by rating agencies has found that companies that were awarded higher IPO grades enjoyed an average price-to-earnings (P/E) ratio of around 18 times.
The P/E ratio of a stock (also called as P/E multiple) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share.
“Companies with higher IPO grades command higher P/E multiples as they have better growth prospects given their strong business fundamentals supported by superior management strength and governance practices — the critical determinants for long-term shareholders' wealth creation,” said Mr Chetan Majithia, Head, Crisil Equities.
A company with an IPO rating of 5/5 commands an average P/E multiple of 18.39 times, while those with grades 2/5, 3/5 or 4/5 command P/E multiples of 10.81 times, 17.82 times and 18.10 times respectively. However, for companies with an IPO grade of 1/5, the average P/E multiple was found to be 10.31 times, indicating poor fundamentals.
To calculate the P/E multiple, the closing stock price of the 117 companies was divided by the reported diluted earnings per share for the trailing four quarters of calendar 2010.
“Sustained positive correlation of P/E multiples with IPO grades reaffirms the importance of the fundamental assessment of a company for the investors at the time of investment in its IPO,” said Mr Tarun Bhatia, Director, Capital Markets.
“The market price of a stock can be influenced by factors other than fundamentals, such as liquidity and market sentiments. Despite this, the positive correlation consistently observed between IPO grades and P/E multiples reflects the broad similarity in the assessment of fundamentals by rating agencies and informed investors, thereby pointing to the efficacy of our grading exercise.”
Grading for companies launching their IPO was made mandatory since May 2007.
While assigning IPO grades, Crisil evaluates the industry, the earnings potential of the company along with the fundamentals and its corporate governance practices. However, it is independent of the issue price of the company.
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