The basis for the price

Every IPO document contains a section called the basis for the issue price. It is the seller's argument that the price is reasonable, and it is more useful than its reputation suggests — provided you read it as an argument rather than a valuation.

Nobody vets the price

Worth restating from chapter 1, because everything here follows from it. SEBI:

Indian primary market ushered in an era of free pricing in 1992. SEBI does not play any role in price fixation. The issuer in consultation with the merchant banker on the basis of market demand decides the price.

There is no regulatory view on whether an IPO is expensive. There is a requirement to disclose how the price was arrived at, and:

The offer document contains full disclosures of the parameters which are taken in to account by Merchant Banker and the issuer for deciding the price. The Parameters include EPS, PE multiple, return on net worth and comparison of these parameters with peer group companies.

Disclosure of reasoning, not approval of a conclusion.

The parameters, and what each one leaves out

Earnings per share. Profit divided by shares. In an offer document it comes in basic and diluted forms, restated, for three years and often a weighted average. Diluted is the one to use: it counts the shares that will exist when outstanding options are exercised. Chapter 5 of the equity subject is why.

P/E multiple. The price band divided by EPS, usually shown at both the floor and the cap. It is the headline number of the section. It is also the most manipulable, because the denominator can be last year, a weighted average of three years, or an annualised recent period — and a company whose last year was unusually good will present the version that flatters it.

Return on net worth. Profit as a percentage of shareholders' funds. It answers a different question from the other two: not what you pay, but how well the company converts the equity it already has into profit. A high P/E against a high return on net worth is at least coherent. A high P/E against a mediocre return on net worth is asking you to pay a premium for average capital efficiency.

The peer group is the argument

Here is where the section is decided.

The comparison is against "peer group companies", and the company selects them. It must disclose who they are and the basis on which they were chosen, which is a real constraint — but within it, the room is enormous.

A company can be made to look cheap by comparing it with the most expensive companies that can plausibly be called comparable, and expensive by the opposite choice. Nobody has to lie. Choosing which listed companies count as peers is a judgement, and the judgement is made by the party setting the price.

So read the peer table with two questions:

Is each one genuinely comparable? Same business, similar size, similar growth, similar margins, similar capital intensity. A profitable niche manufacturer compared against diversified conglomerates is not a like-for-like.

Who is missing? This is the more productive question, and it requires you to know the sector a little. One obvious, cheaper, comparable company left out of the table changes the average the issue is measured against.

Loss-making companies

A company with no profit has no EPS and no P/E, and the section has to do something else — price to sales, enterprise value to revenue, a comparison of growth rates, or a discussion of the path to profitability.

This is legitimate; genuinely valuable companies lose money while growing. Two things follow.

First, the multiples used are weaker evidence. Price to sales says nothing about whether the sales will ever produce profit, and two companies on the same price-to-sales multiple can have completely different economics.

Second, the eligibility route from chapter 6 usually applies. A company that does not meet the profitability conditions must sell at least 75% to institutions and can offer retail no more than 10%. The regulator has already registered that this is a harder thing to assess.

What the section cannot do

It cannot tell you whether the price is right. It is a comparison, and the entire peer group can be expensive at once — a market-wide re-rating, as chapter 2 of the equity subject describes, makes everything look reasonable relative to everything else.

Nor does it contain a discounted cash flow, an intrinsic value, or an opinion from anyone independent. It is the seller's reasoning, shown honestly, with the seller's choices inside it.

The point

Nobody approves an IPO price; the seller must only show its working. EPS, P/E and return on net worth are the disclosed parameters, and the peer group they are compared against is chosen by the party setting the price — so the useful question is which comparable company was left out.