how do investment banks value ipos

Journal of Business Finance & Accounting, 36(1) & (2), 130–160, January/March 2009, 0306-686Xdoi: 10.1111/j.1468-5957.2008.02117.x

How Do Investment Banks Value InitialPublic Offerings (IPOs)?

Marc Deloof, Wouter De Maeseneire and Koen Inghelbrecht∗

Abstract: We investigate the valuation and the pricing of initial public offerings (IPOs) byinvestment banks for a unique dataset of 49 IPOs on Euronext Brussels in the 1993–2001 period.We find that for each IPO several valuation methods are used, of which Discounted Free CashFlow (DFCF) is the most popular. The offer price is mainly based on DFCF valuation, to whicha discount is applied. Our results suggest that DDM tends to underestimate value, while DFCFproduces unbiased value estimates. When using multiples, investment banks rely mostly on futureearnings and cash flows. Multiples based on post-IPO forecasted earnings and cash flows resultin more accurate valuations.

Keywords: company valuation, initial public offerings, investment banks

1. INTRODUCTION

A firm conducting an initial public offering (IPO) needs to have its stock valued beforethe IPO, in order to determine a price range within which the stock will be offered tothe public. There are several methods available for stock valuation. The most widelyused valuation approaches are the dividend discount model (DDM), the discountedfree cash flow (DFCF) method, and valuation approaches that rely on multiples of firmsin similar industries and firms involved in similar transactions.

While there is a very extensive literature on IPOs, and there are many papers on thechoice and accuracy of valuation methods, few papers focus on the valuation of IPOs.We are aware of only one study that investigates the choice of valuation methods forIPOs, and two studies that focus on the accuracy of IPO valuation.1 Roosenboom (2007)investigates how French underwriters value the stocks of firms they take public, andfinds that the valuation methods used depend on IPO firm characteristics, aggregate

∗The authors are respectively from University of Antwerp and Universite catholique de Louvain; ErasmusUniversity Rotterdam; and University College Ghent and Ghent University. They are grateful to an anonymousreferee, An Buysschaert, Marc De Ceuster, Nancy Huyghebaert, Marc Jegers, Rez Kabir, Sophie Manigart andIlse Verschueren for helpful comments and suggestions on an earlier draft of this paper. The usual disclaimerapplies. (Paper received June 2006, revised version accepted September 2008)

Address for correspondence: Marc Deloof, University of Antwerp, Prinsstraat 13, 2000 Antwerp, Belgium.e-mail: [email protected]

1 A number of papers investigate determinants of IPO valuation, but do not consider valuation accuracy(e.g. Krinsky and Rotenberg, 1989; Clarkson, Dontoh, Richardson and Sefcik, 1992; McGuinness, 1993; Klein,1996; Roosenboom and Van der Goot, 2003).

C© 2008 The AuthorsJournal compilation C© 2008 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UKand 350 Main Street, Malden, MA 02148, USA. 130

HOW DO INVESTMENT BANKS VALUE IPOs? 131

stock market returns and stock market volatility. Kim and Ritter (1999) value a sampleof IPOs in the US using price-earnings (P/E) and price-to-book comparables, andfind that these methods lead to very imprecise valuations when historical accountingnumbers are used. However, when forecasted earnings are used, the accuracy of thevaluation improves substantially. Berkman, Bradbury and Ferguson (2000), who value45 newly listed firms in New Zealand, conclude that the best discounted cash flow andP/E valuations have similar accuracy.

An important feature of existing studies on the accuracy of IPO valuation methodsis that they use ex post value estimations by the researcher(s). In Belgium, pre-IPOvalue estimates by the lead underwriting investment bank are often published inthe IPO-prospectus, which is made available at the start of the public offering. Untilrecently, the Banking, Finance and Insurance Commission, the supervising authorityfor Belgian financial markets, requested that this information should be included inthe prospectus for domestic public offerings. In most other countries, this informationis not publicly available. Furthermore, even in Belgium, this is not the case anymoredue to the ‘Prospectus Directive’ (Directive 2003/71/EC), which had to be transposedinto national law by all EU member states before July 1, 2005. In all member states, theIPO prospectus will need to comply with international standards, and a section on thecompany’s valuation/justification of the pricing will not be included anymore.

The availability of this information in Belgian prospectuses allows us to examinehow IPOs are valued, and how this valuation affects the pricing of IPOs. It can beexpected that the accuracy of ex ante valuation by investment banks will differ fromthe valuation accuracy measured by academics, for several reasons. Value estimatesby investment banks may be less accurate because academics are more objective thaninvestment banks, who may be tempted to report valuations that justify a high price,for instance by choosing comparables with high multiples, or a low price, in orderto reduce marketing efforts. On the other hand, value estimates by investment banksmay be more accurate than value estimates by academics because investment bankshave more information for valuation available. Moreover, as the stock market is pricingperceptions of the future and not the future itself, the value estimates by lead underwritersand the offer price, which to some extent will be based on these value estimates, mayinfluence these perceptions and therefore the stock price. However, in an efficientmarket mispricing by underwriters should not affect market valuation.

In this paper, we investigate the valuation and pricing by the underwriters of49 IPOs on Euronext Brussels (formerly the Brussels Stock Exchange) in the 1993–2001 period. We address two research questions. First, we want to know how IPOs arevalued. What valuation models do underwriters use, and how do they set the offerprice, given the value estimates? Second, we investigate which of the valuation models,as used by underwriters, provides the best estimation of the stock market price. Do thesevaluation methods produce unbiased results, and what is the accuracy of the valuations?We find that for each IPO several valuation methods are used, of which DFCF is themost popular method: the DFCF model is used to value all IPOs in the sample. Wealso find that the offer price is set closer to DDM estimates if DDM is applied. This isremarkable, as a comparison of pre-IPO valuations to the average stock price in thefirst month of listing and to the stock price on post-IPO days +1, +10, +20 and +30suggests that DDM tends to underestimate value, while DFCF produces unbiased results.Interviews with investment bankers indicate that underwriters consciously underpriceIPOs, by applying a deliberate discount to DFCF value estimates. DFCF is considered to

C© 2008 The AuthorsJournal compilation C© Blackwell Publishing Ltd. 2008

132 DELOOF, DE MAESENEIRE AND INGHELBRECHT

be the most reliable method. DDM estimates are on average closer to the preliminaryoffer price than other value estimates, because DDM tends to underestimate value.Furthermore, we find that P/E and price/cash flow (P/CF) multiples using earningsand cash flows in the IPO-year lead to less accurate valuations than multiples usingforecasted earnings and cash flows in the year after the IPO, which is consistent withresults of Kim and Ritter (1999). Finally, our results indicate that the final offer price iscloser to the stock market price than pre-IPO value estimates. This is consistent with theexpectation that the final offer price incorporates valuable information about investordemand, obtained by the underwriter during the public offering.

This paper makes two contributions to the literature. First, it explores the frequencyof use of alternative valuation models within the IPO pricing context, providingevidence that changes the consensus in the valuation model choice research area. Ourfinding that DFCF is the most popular valuation model contrasts with previous work,which shows that financial analysts primarily focus on multiples and tend to ignorediscounted cash flow models (e.g., Block, 1999; Barker, 1999a and 1999b; Bradshaw,2002; Demirakos et al., 2004; and Asquith et al., 2005). We put forward various possibleexplanations for the extensive use of DFCF in our sample. First, there may be a lackof comparable firms, which makes methods based on multiples difficult to implement.Second, there may be differences in the perceived importance that investment banksattach to alternative valuation techniques. A third reason may involve time-specificeffects: the majority of our sample went public at the end of the 1990s, a period ofvery high stock market levels during which the use of multiples might have led toovervaluation. Finally, differences in the quality and objectives of IPO prospectusesand equity research papers may account for our finding.

The second contribution is that the paper uses ‘real world’ estimations to investigatethe accuracy of valuation models within the IPO pricing context, in contrast to Kimand Ritter (1999) and Berkman, Bradbury and Ferguson (2000) who use ex-post valueestimates by academics. Some studies examine the accuracy of earnings forecasts in IPOprospectuses, but do not focus on valuation accuracy (e.g., Firth and Smith, 1992; Jaggi,1997; Jelic, Saaudouni and Briston, 1998; Cheng and Firth, 2000; Gonoupolis, 2003;and Jog and McConomy, 2003). Other papers (e.g., DeAngelo, 1990, for managementbuyouts) investigate the ‘real world’ use of valuation models in different settings butdo not discuss valuation accuracy.

This paper is closely related to Roosenboom (2007), who investigates how Frenchunderwriters value the stocks of firms they bring public. Our paper complementsand extends the work of Roosenboom in several respects. First, while the study ofRoosenboom specifically focuses on how IPOs are valued, we also offer empiricalevidence on the accuracy and bias of the implemented valuation methods. Second,we provide much more detailed information about multiple valuation, whereasRoosenboom combines all multiple valuation methods into one single group. Third,we use interviews to interpret the quantitative results and explain the relation betweenthe estimates derived by alternative valuation models and the preliminary offer price.Fourth, while Roosenboom investigates the French stock market, our study offersempirical evidence on the valuation of IPOs for another, smaller stock market. Ourfindings reveal some interesting differences as compared to Roosenboom. Contraryto Roosenboom, we find that DFCF and not multiples is the most important valuationmodel. Our results also suggest that investment bankers base the preliminary offerprice primarily on DFCF regardless of the characteristics of the analyzed firm. The



preliminary offer price is derived by applying a discount to the DFCF valuationestimate.2

The remainder of the paper is organized as follows. In the next section we brieflydiscuss the choice and accuracy of valuation models. Section 3 describes the IPO processin Belgium. The sample and the methodology we use are discussed in Section 4. InSection 5 the valuation outcomes are compared to the IPO offer price and the averagestock market price in the first month of listing. Section 6 discusses the relation betweenIPO valuation and underpricing. Finally, Section 7 presents some conclusions.

2. VALUATION MODEL CHOICE AND THE ACCURACY OF VALUATION MODELS

(i) Valuation Model Choice

A number of authors have argued that multi-period valuation models based ondiscounted cash flows or residual income are superior to single-period multiplevaluation approaches, which are likely to result in less accurate valuations (e.g.,Copeland et al., 2000; Palepu et al., 2000; and Penman, 2007). However, the empiricalevidence on valuation models used by professional investors and financial analystsstands in contrast to the theoretical superiority of multi-period valuation models. Thestrongest and most consistent empirical finding is the primary importance of the P/Eratio (e.g., Govindarajan, 1980; Previts et al., 1994; and Yap, 1997). Another consistentfinding is that DFCF models, technical analysis and beta analysis are rarely used ininvestment decisions (Arnold and Moizer, 1984; Pike et al., 1993; and Block, 1999). Forequity analysts, the most prevalent base for target prices are P/E ratios and forecastedlong-term earnings growth rates, or a combination of these two constructs (the PEGratio). They rarely use present value techniques in equity valuation (Block, 1999;and Bradshaw, 2002). The inherent uncertainty of projecting future cash flows anddetermining an appropriate discount rate may make multi-period cash flow valuationappear too difficult (Barker, 1999a). Asquith et al. (2005) find that almost all analystsuse earnings multiples in their reports. Only 12.8% of the analyst reports in theirsample include any variant of DFCF, while 25.1% of the reports include asset multiples.Another finding of the empirical literature is that the use of option pricing models orthe residual income model is extremely limited (Demirakos, Strong and Walker, 2004).

The use of valuation models in analyst reports varies according to industry. Barker(1999b) finds that the P/E ratio is the dominant valuation model in the services,industrials and consumer goods sector. The dividend yield is more important forfinancials and utilities. Comparative valuation models are more popular in relativelystable sectors where conventional accounting does a better job of capturing the valueof the firm (Demirakos, Strong and Walker, 2004).

A number of studies focus on the valuation of high-tech and internet stocks,examining whether traditional valuation frameworks are relevant for such firms (e.g.,Hand, 1999 and 2000; Schwartz and Moon, 2000; Trueman et al., 2000; Demers and Lev,2001; and Bartov et al., 2002). The results of these studies are mixed: while some studies

2 Another difference between our study and Roosenboom (2007) is that our analysis is based on informationincluded in the IPO-prospectus, which is reviewed by and requires approval from a regulatory agency (inBelgium: the Banking, Finance and Insurance Commission) before it can be published, while the analysis ofRoosenboom is based on pre-IPO underwriter analyst reports.



find that the traditional valuation models play a key role, others find that valuationstend to differ from the traditional methods. A recent survey with telecommunicationcompany equity analysts by Glaum and Friedrich (2006) shows that both DFCF andmultiples are always used, but that DFCF is the dominant technique. Analysts usemultiples but only to validate their DFCF results, not as an independent valuationtool. Most analysts indicated changes in the relative importance of valuation modelswith DFCF now being more important than at the end of the 1990s.

(ii) The Accuracy of Valuation Models

Various studies have examined the accuracy of valuation models. Some of these studiesfocus on multiples valuation, and provide mixed results on which multiples have thehighest valuation accuracy (e.g., Beatty, Riffe and Thompson, 1999; Kim and Ritter,1999; and Liu, Nissim and Thomas, 2002). A number of papers investigate how thechoice of comparable firms affects accuracy of multiples. Profitability, growth andrisk are important variables in peer group selection, and the use of harmonic meansgenerates the best results (e.g., Boatsman and Baskin, 1981; Alford, 1992; Cheng andMcNamara, 2000; and Bhojraj and Lee, 2002). A consistent result is that multiples basedon forecasted earnings lead to higher valuation accuracy than multiples using trailingearnings (see Kim and Ritter, 1999; Liu, Nissim and Thomas, 2002; and Lie and Lie,2002). This is not unexpected, as other studies suggest that earnings forecasts captureinformation on value that is not reflected by historical earnings (e.g., Tse and Yaansah,1999; Liu and Thomas, 2000; and Barniv and Myring, 2006). Yee (2004) shows that ina setting of unobserved information, forward earnings are better valuation attributesthan trailing earnings. Furthermore, the value-relevance of earnings is enhanced bya focus on permanent, as opposed to transitory components of earnings (see Barker,1999b, for a review).

Some studies compare the accuracy of multiples valuation and discounted cashflow valuation. Kaplan and Ruback (1995) examine the discounted cash flowand comparable firm approaches in the context of highly leveraged transactions,and conclude that both approaches are useful and reliable. According to Kaplanand Ruback, discounted cash flow valuation methods perform at least as well asvaluation approaches using companies in similar industries and companies involvedin similar transactions. Gilson, Hotchkiss and Ruback (2000) find that, for firms thatreorganize in bankruptcy, the discounted cash flow and comparable firm approacheshave about the same degree of accuracy and lead to estimates that are generallyunbiased but not very precise. Berkman, Bradbury and Ferguson (2000), value 45newly listed firms in New Zealand, and also conclude that the best discounted cashflow and multiples valuations have similar accuracy. Asquith et al. (2005) find that theaccuracy of earnings multiples and DFCF used by equity analysts in predicting pricetargets is fairly similar. Analysts are least successful in predicting target prices when theyuse EVA or a ‘unique’ alternative valuation method.

Penman and Sougiannis (1998) and Francis, Olsson and Oswald (2000) compareaccrual earnings valuation to discounted cash flow valuation. Interestingly, both studiesfind that accrual earnings techniques produce lower valuation errors than discountedcash flows and dividends. However, Lundholm and O’Keefe (2001) claim that thesuperiority of accrual earnings valuation found by these papers is misguided, andis only due to the researchers’ actual implementation containing inconsistencies,



as accrual earnings valuation and discounted cash flow valuation are theoreticallyequivalent (Ohlson, 1995). Bernard (1995) and Walker (1997) argue that accrualearnings valuation is superior under information-constrained conditions.

3. THE IPO PROCESS IN BELGIUM

As our analysis focuses on the valuation of IPOs, it is useful to briefly describe the IPOprocess in Belgium. This process is very similar to IPO procedures in other countries,such as the US and the UK. Once the board of directors of a company has decided to gopublic, the company will hire an investment bank to underwrite the offering. Usually,a group of co-underwriters is formed to help sell the issue to the public. A profounddue diligence is carried out, checking business, legal, financial and tax issues, and alllegal documentation is put together. Limited pre-marketing activity may take placeto obtain some feedback from institutional investors about their potential interest forthe new issue. A prospectus is drafted which contains, amongst other things, financialinformation about the company and the terms of the offer. It is the only document thecompany can use to communicate with potential investors during the IPO. In Belgium,it will very often contain estimates of the company value by the lead underwriter. Beforethe shares can be offered to the public, the prospectus has to be approved by the BelgianBanking, Finance and Insurance Commission.

During the offering period, which lasts one or two weeks, investors can place bids forshares, usually within a range of potential offer prices, and sometimes at a unique offerprice. The offer price range depends on the outcomes of the underwriter’s valuations,and may also reflect information obtained from pre-marketing. Most IPOs in Belgiummake use of the bookbuilding method, in which the underwriter builds a book oflikely orders and uses this information to set the final offer price. The underwriterorganizes road shows during which the new issue is marketed to investors. A few daysafter the public offering period, the final offer price is set within the offer pricerange (if applicable), shares are allocated to investors, and the share starts tradingon the stock market. The final offer price is therefore set after the underwriter hasobtained information about investor demand, which is not available at the time whenthe underwriter sets the preliminary offer price range on the basis of the value estimates.The final offer price also takes into account current market conditions, and is theoutcome of a negotiation process between the issuer, and the underwriter’s corporatefinance and sales team.

4. SAMPLE AND METHODOLOGY

(i) Sample

Our sample includes 49 IPOs on Euronext Brussels from 1993 to 2001, for whichvaluation information is available. Between January 1984 and June 2005, 103 companieshave been introduced on the First Market or on the New Market of Euronext Brussels.The New Market (also called Euro.NM Belgium) was set up in 1997 for young, highgrowth firms. The 30 IPOs before 1993 could not be included in the sample because theprospectus did not contain information on value estimates. For the limited number ofIPOs after 2001, the prospectus also contains insufficient valuation information, due tothe EU ‘Prospectus Directive’. Some IPOs in the period 1993–2001 which were primarilyaimed at international investors, also had to be left out of the sample due to a lack of



detailed valuation information (e.g., Interbrew and Mobistar). After excluding IPOsof mutual funds, financial institutions and holding companies, we eventually retain49 IPOs, of which 15 were listed on the New Market.

Table 1 shows that most companies in our sample went public in the hot IPO marketat the end of the 1990s. The IPO firms are active in a wide range of industries, includingboth ‘high tech’ industries and industries that do not rely on sophisticated technologies(see Table 2).

Table 3 presents some descriptive statistics. The median firm introduced at EuronextBrussels offered 858,678 shares at a preliminary offer price of 28.8 EURO. Thepreliminary offer price is the midpoint of the minimum and maximum offer prices, or,if the shares are not offered within a price range, the unique offer price (see Kim andRitter, 1999).3 The initial returns, which are calculated as [average price in the firstmonth of listing/offer price] –1, were generally substantial on Euronext Brussels: themedian initial return is +9.5%, and the mean initial return is +19.3%.4

For most IPOs, at least a part of the shares are sold by existing shareholders: nine firmsoffer only existing shares; 25 firms offer both existing and new shares; 15 firms offer onlynew shares.5 These findings are consistent with evidence for other European countriesthat a major motivation for European firms to go public is to allow the controllingshareholder to divest from the firm (see Rydqvist and Hogholm, 1995; Pagano, Panettaand Zingales, 1998; and Ritter, 2003).

All lead underwriters are Belgian banks, with the exception of ABN Amro Rothschild,which is co-lead underwriter of two IPOs, and Indosuez, which is co-lead underwriterof one IPO. The (co-)lead underwriters are Generale Bank/Fortis Bank (14 IPOs),Smeets Securities/Delta Lloyd Securities (12 IPOs), Bank Brussel Lambert (9 IPOs),KBC Securities (7 IPOs), Petercam (7 IPOs), Paribas/Artesia Bank/Dexia (5 IPOs),Bank De Groof (4 IPOs), Lessius (1 IPO), Delen & Co (1 IPO), Van Moer Santerre(1 IPO) and Nedee (1 IPO).

Table 1Distribution Across Years

Forty Nine IPOs on Euronext Brussels Between 1993 and 2001 by Year of Offering

Year of Offering Number of IPOs

1993 11994 11995 01996 21997 101998 151999 142000 52001 1

3 Thirty six out of 49 IPOs in our sample made use of bookbuilding, the remaining IPOs involved fixed pricemechanisms.4 Stock prices were taken from Datastream. Stock prices for three IPOs were not reported in Datastream;they were manually collected from De Tijd, the main Belgian financial newspaper.5 Not surprisingly, all firms introduced on the New Market, which aims at young high growth firms, offernew shares.



Table 2Distribution Across Industries

Forty Nine IPOs on Euronext Brussels Between 1993 and 2001 by Industry

Industry Number of IPOs

Software 6Food processors 4Computer services 3Clothing and footwear 2Commercial vehicles 2Diversified industry 2Environmental control 2Leisure facilities 2Media agencies 2Medical equipment and supplies 2Pharmaceuticals 2Restaurants and pubs 2Textiles and leather goods 2Brewers 1Chemicals – advanced materials 1Computer hardware 1Construction materials 1Consumer electronics 1Electrical equipment 1Electronic equipment 1Gas distribution 1Insurance non-life 1Non-ferrous materials 1Paper 1Personal products 1Publishing and printing 1Retailers 1Soft goods 1Telecom equipment 1

Source: Datastream.

(ii) Methodology

In a first step, we examine how IPOs are valued by (a) considering the frequency of useof different valuation methods and (b) assessing the relative importance of valuationmethods in determining the preliminary offer price. For each valuation method wecompute the proximity of value estimates to the preliminary offer price by the naturallog of the ratio of the estimated value to the preliminary offer price. While we will referto this measure as a ‘pricing error’, it should not be interpreted as an error in the strictsense, but only as a quantification of the proximity of value estimate and preliminaryoffer price. We evaluate the degree of central tendency of the preliminary offer priceto value estimates by the percentage of differences within 15% and the mean absoluteerror. Mean and median pricing errors are calculated to indicate the extent to which thepreliminary offer price is set higher (negative pricing error) or lower (positive pricingerror) than the value estimates. We will focus on median errors, which are less affectedby outliers than mean errors (although the difference in our sample is limited).



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In a second step, we will investigate which of the valuation models provides the bestestimation of the stock market price. The proximity of estimated value to the marketvalue is computed as the natural log of the estimated value over market value. As in otherstudies of valuation methods, we use mean and median valuation errors to indicate theextent to which value estimates are biased: do the value estimates tend to be on averagehigher or lower than the market value? The accuracy of valuation is measured by thepercentage of valuation errors within 15% and the mean absolute error, both indicatingthe dispersion of the valuation errors.6

Our measure of valuation accuracy, which is the standard measure in the literature,is based on a comparison of value estimates with stock market prices. This measureassumes that (1) value estimates reported in the prospectus are the actual valueestimates of the underwriter, and (2) stock market prices reflect fair value. Regardingthe first assumption, it cannot be ruled out that the reported value estimates are lowerthan the actual estimations of the underwriter. It is widely acknowledged that IPOs areunderpriced. If underwriters consciously underprice IPOs, they may have an incentiveto report value estimates that are lower than their ‘true’ value estimates. If this is thecase for the IPOs in our sample, we expect to find that the reported value estimatesfor different methods tend to underestimate stock market prices. However, it can beargued that even if the reported value estimates are lower than the actual value estimatesof the underwriter, a comparison of valuation errors will yield consistent results, aslong as reported value estimates are underpriced to the same degree. Moreover, weinterviewed representatives of seven lead underwriters, who covered 45 of the 49 IPOsin our sample.7 They all claim that the valuations reported in the IPO prospectus reflectthe true outcomes of their valuation models.

The assumption that stock market prices reflect fair value, implies that the stockmarket is efficient and that any underpricing is corrected for very fast when tradingstarts. Most studies on underpricing indeed find abnormal initial returns on the first dayof trading, but not afterwards, which suggests that underpricing is corrected at the firsttrading day (e.g., Ritter, 1998). Investors may also overreact when trading starts, therebydriving stock prices above fair values. Some studies on the long-run underperformanceof IPOs find support for this theory (e.g., Aggarwal and Rivoli, 1990; Ritter, 1991;Loughran and Ritter, 1995; Ritter and Welch, 2002; Purnanandam and Swaminathan,2004; and Alvarez and Gonzalez, 2005). Stocks can also become overvalued becauseunderwriters tend to support prices in the after-market (e.g., Aggarwal and Rivoli, 1990;and Schultz and Zaman, 1994). Stock market prices might therefore not reflect fairvalue at all times. However, it can be argued that if the underwriter bases his valuationsupon the same expectations as the stock market, a comparison of valuation errors willyield consistent results, regardless of overvaluation in the stock market. In order tominimize the risk that our empirical results are driven by short-term underpricing oroverpricing, we measure stock market prices (‘fair value’) over a range of different timeperiods (post-IPO day 1, +10, +20, +30, average first month).

6 See e.g., Kaplan and Ruback (1995), Kim and Ritter (1998) and Gilson et al. (2000). Kaplan and Rubackalso use the mean squared error as a measure of valuation accuracy. The mean squared error assumes thatthe ‘cost’ of valuation errors for the user of the valuation method, such as costs arising from mispricing,increase quadraticly, while the mean absolute error assumes that the cost increases are linear. We measuredthe mean squared error for all the analyses presented in this paper. The results (not reported) fully confirmthose of the mean absolute error.7 The objective of these interviews is explained at the end of this section.



Another potential problem when examining the valuation accuracy is that theinformation set changes when trading of the IPO begins, and investors are not restrictedto the investment bank’s information set (Berger, 2002). This would mean that eventhough the value estimates of underwriters may be right at the time they were made(ex ante), they may be wrong afterwards (ex post), potentially distorting our results.However, given the rather short period of time between the publication of the IPOprospectus and the first day of trading, we expect this effect to be limited. Moreover,the period between the publication date of the prospectus and the first trading datefalls within the ‘blackout’ or ‘silent period’, during which there are strong restrictionswith respect to the release of new information about the company.

Our quantitative measures, as described above, do however suffer from somedrawbacks. First, they do not provide information about the practical implementationof the valuation models. Second, they do not give us a clear answer on which valuationmethod underwriters really rely to price IPOs. Qualitative research methods allow iden-tifying hitherto unexpected and undisclosed relationships. Combining quantitativeand qualitative research methods compensates for one another’s weaknesses, leadingto more relevant and reliable findings than would be achieved by either method inisolation (Barker, 1999b). Thus, in order to gain insight into the way underwritersvalue and price IPOs, seven investment bankers, who were the lead underwriter of45 of the 49 IPOs in our sample, were interviewed. The semi-structured interviewslasted 60–90 minutes; they were tape-recorded and transcribed in text documents. Themajor advantage of semi-structured interviews is that they allow interviewees to expressopinions on wide-ranging predetermined issues and also to respond to supplementaryquestions seeking clarity, consistency and full explanation. These benefits have tobe weighted against potential problems of subjectivity and bias in the data and theinterpretation of the data (e.g., Barker, 1999a; and Silverman, 2006). Conductinginterviews enables us to obtain differentiated answers, especially in the case of complexissues. Moreover, the interviewer can remove possible misunderstandings by clarifyingcertain aspects or seeking further explanation which results in higher validity of data(Neuman, 1999). A recent study by Imam, Barker and Clubb (2008) also combinesqualitative and quantitative research techniques. They investigate analysts’ use ofvaluation models by offering a content based analysis of equity research reports andusing a semi-structured interview based approach to interpret the quantitative results.

5. RESULTS

(i) Valuation Model Choice

How do the lead underwriters value the firm? Table 4 contains the valuation methodsused to value the 49 IPOs, and the number of cases in which they are applied.8 Alllead underwriters mention only the use of generally accepted valuation methods andseem to avoid eccentric multiple valuation methods as the ones described by Fernandez(2001).9 DFCF is the most popular method: it is used to value all IPOs. DDM is used for

8 Some IPO prospectuses mention the use of a valuation method for which no estimation result is given.These are not included in Table 4.9 Fernandez (2001) discusses the valuation of internet provider Terra-Lycos in 2000 by a number of banks,which use weighted averages of a curious mix of multiples, based on e.g., GNP per capita, number ofinhabitants, capitalization per subscriber, enterprise value per page view, and capitalization per page view.



Table 4Valuation Methods Used by Lead Underwriters

Valuation Method Number of IPOs

Discounted free cash flow 49Dividend discount model 24Multiples 40� Price/earnings 37

Peer group 34Stock market 14Growth shares 2

� Price/cash flow 17Peer group 15Stock market 8Growth shares 3

� EnterpriseValue/EBITDA (peer group) 8� EnterpriseValue/sales 3

Peer group 3Stock market 1

� Price/book (peer group) 1� Dividend yield (peer group) 2� P/E-to-growth (peer group) 1

Notes:The number of IPOs for which the IPO-prospectus, which is made available at the start of thepublic offering, provides a value estimation based on a particular valuation method, for 49 IPOs onEuronext Brussels between 1993 and 2001.

24 IPOs, and a multiples approach is used to value 40 IPOs. All underwriters use at leasttwo different valuation methods. Although multiple valuation is often used in practice,it is flawed from a theoretical perspective. Its economic rationale is questionable as theanalysis is not anchored in fundamentals like future cash flows, growth opportunitiesand risk that tell us about value independently of market prices. Next, the method ofmultiples assumes that the market is efficient in setting prices for the comparables.Moreover, multiple valuation is often of a static nature, whereas discounted cash flowmethods can better handle the dynamic nature of a business environment.

Conceptual problems aside the method of comparables also has problems in imple-mentation. Identifying peers with similar operating and financial characteristics is dif-ficult. The method leaves too much room for ‘playing with mirrors’ and too much free-dom for the analyst to obtain a desired valuation. In addition, different multiples givedifferent valuations—it is not clear which is most reliable (Penman, 2007). Moreover,failure to make appropriate adjustments to peer companies’ financial statements and asimple reliance on mean or median peer group multiples without comparative analysismay further cause relative valuation by multiples to produce inaccurate outcomes(Pratt, Reilly and Schweihs, 2000). However, in contrast to DFCF, multiple valuationdoes not require the tough work of adequately estimating cash flows and appropriatediscount rates (cf. Lie and Lie, 2002). P/E and P/CF are the most popular multipleapproaches: P/E is applied for 37 IPOs and P/CF is applied for 17 IPOs. Othermultiple approaches used are EnterpriseValue/EBITDA (8x), EnterpriseValue/Sales(3x), Price/Book (1x), Dividend yield (2x) and P/E-to-Growth (1x).

A problem with using multiples to value Belgian IPOs is that the number of firmslisted on Euronext Brussels is limited. At the end of 1999 only 144 firms were listed, many



of which are financial institutions and holding companies. It is therefore often difficultto find a sufficient number of comparable firms. In several cases, the underwritercompares the IPO to the Euronext Brussels stock market, as well as to a peer groupof firms, in order to estimate value. For a few IPOs, value is also estimated using theaverage P/E or P/CF of growth shares on Euronext Brussels.

Multiples can be based on historical earnings or cash flows, but also on forecastedearnings and cash flows. Most multiples used in our sample are based on current year’sforecasted earnings and cash flow (year 0) or next year’s forecasted earnings or cash flow(year +1). In a limited number of cases the underwriter also uses historical earningsand cash flow in the year before the IPO (year −1) and/or the forecasted earningsand cash flow for the second post-IPO year (year +2). This leads to a wide range ofmultiples used by investment banks, along three dimensions: [1] type of multiple (P/E,P/CF, Price/book ..), [2] the firms to which the IPO is compared (peer group, stockmarket, growth shares), and [3] the timing of the multiple (years −1, 0, +1, +2). Inthe remainder of the paper, we will investigate the estimations of the most frequentlyused multiples: P/E and P/CF, for a peer group and for the stock market, in years 0and +1.

The usefulness of valuation methods may vary according to firm characteristics(Roosenboom, 2007). In order to identify distinctions between the firms that are valuedwith each valuation model, we report median values for key firm characteristics drawnfrom the prospectuses and test the significance of differences using the non-parametricMann-Whitney test. The firm characteristics we consider are firm age, firm size,profitability, sales growth and dividend payout. We measure firm age as the differencebetween the IPO year and the founding year. According to Kim and Ritter (1999), itis more difficult to forecast the future dividends of younger firms without establishedtrack records. Firm size is proxied by total assets in the accounting year preceding theIPO (expressed in million EURO). Larger firms are likely to have more stable dividendswhich are easier to forecast. Profitability is measured by EBIT/Sales, which is the ratio ofcurrent year’s forecasted earnings before interest and taxes to current year’s forecastedsales, and by EBIT/Total assets, which is the ratio of current year’s forecasted earningsbefore interest and taxes to current year’s total assets. Underwriters are more likely tovalue highly profitable firms with DDM, as these firms can pay out substantial dividends.Furthermore, firms that are only marginally profitable or loss reporting in the currentyear are more likely to be valued with forward looking multiples than with multiplesbased on current profits. Sales growth is equal to forecasted sales growth during thecurrent year. We expect that high growth firms are more likely to be valued withmultiples since multiples are better suited to value growth opportunities than DDM(Roosenboom, 2007). Moreover, high growth firms are more likely to retain earningsinstead of paying them out as dividends. They are therefore less likely to be valued withDDM. Dividend payout is dividend over net income expected for the year after the IPO.(High) dividend paying firms are more likely to be valued with DDM.

Table 5 compares firms valued with DDM to those for which DDM is not usedand presents similar information for P/E and P/CF. For firms valued with P/E, wefurther differentiate between firms valued with current P/E only, forward P/E onlyand both current and forward P/E.10 As all the firms in our sample use DFCF, wecannot differentiate between firms valued with DFCF and other firms. Table 5 reveals

10 One IPO was valued with P/E based on earnings in the previous year only.



Tab

le5

Valu

atio

nM

etho

dsU

sed

byL

ead

Und

erw

rite

rs:M

edia

nVa

lues

for

Firm

Cha

ract

eris

tics

Met

hods

Use

d:D

DM

P/E

P/E

P/E

P/C

F

Yes

No

Yes

No

Cur

rent

Cur

rent

and

Cur

rent

and

Forw

ard

Yes

No

Onl

yFo

rwar

dFo

rwar

dO

nly

Firm

age

(Yea

rs)

21.5

0∗∗∗

7.00

10.0

012

.00

16.0

011

.50

11.5

0∗∗6.

0026

.50∗∗

∗8.

00Fi

rmsi

ze(M

ioE

UR

O)

55.6

3∗∗∗

10.2

521

.73

17.6

014

7.82

42.8

842

.88

2.84

72.4

5∗∗∗

16.5

1E

BIT

/Sal

es(%

)8.

19∗∗

∗3.

405.

936.

9110

.07

8.19

8.19

∗∗∗

−3.6

57.

376.

81E

BIT

/Tot

alas

sets

(%)

9.52

∗∗∗

1.29

4.89

6.29

7.77

10.3

310

.33∗∗

∗−7

.06

8.37

5.00

Sale

sgr

owth

(%)

8.89

∗∗∗

56.6

728

.20

36.0

010

.15

15.3

115

.31

66.3

89.

82∗∗

40.8

7D

ivid

end

payo

ut(%

)30

.00∗∗

∗0.

000.

0010

.00

35.0

030

.00

30.0

0∗∗0.

0032

.50∗∗

∗0.

00N

umbe

rof

met

hods

used

52

42

56

62

72

Num

ber

ofob

serv

atio

ns24

2537

124

2020

1217

32

Not

es:

Aco

mpa

riso

nof

med

ian

valu

esof

key

firm

char

acte

rist

ics

for

diff

eren

tva

luat

ion

met

hods

used

tova

lue

49IP

Os

onE

uron

ext

Bru

ssel

sbe

twee

n19

93an

d20

01.F

irm

age

isth

edi

ffer

ence

betw

een

IPO

year

and

foun

ding

year

;Fir

msi

zeis

tota

lass

ets

inac

coun

ting

year

prec

edin

gth

eIP

O(i

nM

ioE

UR

O);

EB

IT/S

ales

isth

era

tioof

curr

ent

year

’sfo

reca

sted

earn

ings

befo

rein

tere

stan

dta

xes

tocu

rren

tye

ar’s

fore

cast

edsa

les;

EB

IT/T

otal

asse

tsis

the

ratio

ofcu

rren

tye

ar’s

fore

cast

edea

rnin

gsbe

fore

inte

rest

and

taxe

sto

curr

ent

year

’sto

tala

sset

s;Sa

les

grow

this

fore

cast

edsa

les

grow

thdu

ring

the

curr

ent

year

;Div

iden

dpa

yout

isdi

vide

ndov

erne

tin

com

eex

pect

edfo

rye

araf

ter

IPO

;N

umbe

rof

met

hods

used

isth

enu

mbe

rof

valu

atio

nm

etho

dsus

edby

the

lead

unde

rwri

ter.

∗ ,∗∗

and

∗∗∗

deno

tesi

gnifi

cant

diff

eren

cefr

omze

roat

the

10%

leve

l,th

e5%

leve

land

the

1%le

vel,

resp

ectiv

ely,

base

don

the

Man

n-W

hitn

eyte

st.

Sour

ce:p

rosp

ectu

ses.



that firms valued with DDM are relatively older, larger and more profitable. Theyalso have a higher dividend payout and lower forecasted sales growth. This is in linewith the findings of Roosenboom (2007). While there are no significant differencesbetween firms valued with P/E and other firms, we do find that young, loss makingfirms without dividends are more likely to be valued with forward P/E only than withcurrent (and forward) P/E. Remarkably, companies valued with the P/CF multipletend to be relatively old and large, have low growth prospects and pay dividends. Themedian number of methods used to value P/CF firms is seven, while the overall mediannumber of methods used is only three. This may suggest that the P/CF multiple is notconsidered to be a central valuation method, but is only used as a supplementarymethod by underwriters of large, mature firms.

(ii) Valuation Models and IPO Pricing

In this section, we investigate which valuation model is most closely linked to thepreliminary offer price and on which valuation method(s) lead underwriters relymost to set the preliminary offer price.11 As discussed in Section 4(ii), we use bothquantitative and qualitative analysis.

(a) Quantitative Analysis

Table 6 presents results of our quantitative analysis for DFCF, DDM and the mostcommonly used multiple approaches: P/E and P/CF based on a peer group or stockmarket, calculated for year 0 and year +1.12 The median pricing error for DFCF is+14.1%: lead underwriters set the preliminary offer price significantly lower than thevalue estimates based on DFCF (p-value of the Wilcoxon signed rank test is less than0.001). The median error for DDM is +3.4% and only significant at the 10% level(p-value = 0.094). The median errors for estimates based on multiples vary widely: theyrange from −9.8% to +21.7%. These results would suggest that the lead underwritersrely primarily on DDM to determine the preliminary offer price.

We measure the degree of central tendency of value estimates towards thepreliminary offer price by the percentage of differences within 15% and the meanabsolute error. For only 27 out of 49 IPOs (55.1% of the sample), the estimates basedon DFCF are within 15% of the preliminary offer price. On the other hand, the DDMestimate is within 15% of the preliminary offer price for 22 out of 24 IPOs (91.7%) forwhich a DDM value is estimated. For the multiples estimates, the percentages within15% are also much lower than for DDM. A comparison of the mean absolute errorfor the different valuation methods leads to the same conclusions as the comparisonbased on the percentage within 15%. A t-test of differences in the mean absolute errorreveals that the mean absolute error for DDM estimates is significantly smaller than themean absolute error of DFCF estimates (p-value = 0.002), and smaller than the meanabsolute error for P/E peer group estimates in year +1 (p-value = 0.003), the mostfrequently used multiple estimation method. The mean absolute error for DFCF andP/E peer group (year +1) estimates are not significantly different (p-value = 0.40).

11 The results presented in this section are qualitatively similar if we use the final offer price instead of thepreliminary offer price.12 These multiples are consistently closer to the preliminary offer price than the multiples for which noresults are presented.



Tab

le6

Pre-

IPO

Valu

eE

stim

ates

and

Prel

imin

ary

Off

erPr

ice:

AC

ompa

riso

nof

Dif

fere

ntVa

luat

ion

Met

hods

Dis

coun

ted

Div

iden

dP/

EPe

erP/

EPe

erP/

ESt

ock

P/E

Stoc

kP/

CF

Peer

P/C

FPe

erP/

CF

Stoc

kP/

CF

Stoc

kFr

eeC

ash

Dis

coun

tG

roup

Gro

upM

arke

tM

arke

tG

roup

Gro

upM

arke

tM

arke

tVa

luat

ion

met

hod:

Flow

Mod

el(y

ear

0)(y

ear+1

)(y

ear

0)(y

ear+1

)(y

ear

0)(y

ear+1

)(y

ear

0)(y

ear+1

)

Med

ian

14.1

%3.

4%−1

.0%

11.2

%−7

.2%

7.6%

21.7

%20

.1%

−9.8

%7.

7%M

ean

14.4

%3.

2%−2

5.8%

7.4%

−16.

8%9.

5%24

.9%

24.1

%−3

.8%

5.8%

Stan

dard

devi

atio

n13

.2%

8.7%

121.

5%14

.1%

30.8

%23

.5%

34.1

%31

.1%

21.6

%14

.4%

Inte

rqua

rtile

rang

e15

.0%

12.0

%34

.0%

16.8

%26

.8%

6.6%

32.4

%22

.4%

18.5

%13

.4%

Perc

enta

gew

ithin

15%

55.1

%91

.7%

42.9

%63

.0%

50.0

%66

.7%

33.3

%25

.0%

62.5

%50

.0%

Mea

nab

solu

teer

ror

15.8

%7.

9%47

.0%

13.9

%23

.2%

16.6

%30

.4%

29.4

%17

.6%

13.5

%

Num

ber

ofob

serv

atio

ns49

2421

2712

1212

128

6

Not

es:

Aco

mpa

riso

nof

the

mos

tco

mm

only

used

met

hods

tova

lue

49IP

Os

onE

uron

ext

Bru

ssel

sbe

twee

n19

93an

d20

01.

Pric

ing

erro

rsar

eco

mpu

ted

asth

ena

tura

llog

ofth

era

tioof

the

estim

ated

valu

eto

the

prel

imin

ary

offe

rpr

ice.

The

prel

imin

ary

offe

rpr

ice

isth

em

idpo

into

fthe

min

imum

and

max

imum

offe

rpr

ices

,or

,if

the

shar

esar

eno

tof

fere

dw

ithin

apr

ice

rang

e,th

epr

e-sp

ecifi

edof

fer

pric

e.T

hepr

e-IP

Ova

lue

estim

ates

are

publ

ishe

din

the

IPO

-pro

spec

tus,

whi

chis

mad

eav

aila

ble

atth

est

arto

fthe

publ

icof

feri

ng.T

hefir

stfo

urro

ws

repo

rtm

edia

n,m

ean,

stan

dard

devi

atio

nan

din

terq

uart

ilera

nge

ofer

rors

.Tw

om

easu

res

ofva

luat

ion

accu

racy

are

repo

rted

:the

perc

enta

geof

erro

rsw

ithin

15%

,and

the

mea

nab

solu

teer

ror.

For

each

valu

atio

nm

etho

d,th

enu

mbe

rof

obse

rvat

ions

depe

nds

onth

enu

mbe

rof

IPO

sfo

rw

hich

the

met

hod

isap

plie

d.



Again these results seem to suggest that the preliminary offer price is driven by DDMif applied.

Another interesting finding in Table 6 is that the multiples valuations for year +1are consistently closer to the preliminary offer price than the multiples valuations forthe IPO year 0: underwriters seem to rely more on forecasted future multiples thanon current multiples. The p-value of a t-test of differences in the mean absolute errorbetween P/E peer group (year 0) and P/E peer group (year +1) is 0.002.

Some valuation methods will be more appropriate to use than others. Individualvaluation models may have strengths and weaknesses that are complementary. Al-ternatively, the usefulness of a given valuation model may vary according to certainexogenous factors (Barker, 1999b). The underwriter has to choose which methods areappropriate and which are not. The results in Table 6 may be influenced by this choice.For example, the difference between DFCF and DDM might be caused by the 15 IPOsfor which DFCF was used but DDM was not. For the 24 IPOs for which both methodswere used, the DFCF estimates might then be much closer to the preliminary offer pricethan the results in Table 6 suggest. We therefore also investigate the relation betweenthe IPO preliminary offer price and different value estimates by a pairwise comparisonof valuation methods, for those IPOs that are valued with both methods. The resultsare presented in Table 7. DFCF, DDM and P/E based on a peer group for year +1 arecompared pairwise. We concentrate on the P/E based on a peer group for year +1because our performance measures indicate that this multiple is the one closest to thepreliminary offer price. Moreover, P/E based on a peer group is the most commonlyused multiple. We also compare P/E based on a peer group in year 0 and year +1. Allresults in Table 7 confirm those in Table 6.

So far, we have relied on univariate analysis to investigate the relation betweenpre-IPO value estimates and preliminary offer price. For the IPOs in our sample,underwriters always use at least two valuation approaches. It therefore seems likely thatthe preliminary offer price is based on more than one value estimate. Table 8 reportsthe results of OLS-regressions of the natural logarithm of the preliminary offer priceon the natural logarithm of value estimates by the lead underwriter. All variables areexpressed as a natural logarithm because of large size differences. The coefficients ofthe explanatory variables should provide an estimate of the weight underwriters attachto a particular valuation method. However, the results in Table 8 have to be interpretedwith caution: the number of observations for each combination of valuation methodsis limited, and the correlations between the pre-IPO value estimates of the valuationmethods are very high.

The first column of Table 8 reports results for 13 IPOs which were valued with DFCF,DDM and P/E Peer Group Year +1 (the most commonly used multiple). The DDMcoefficient is 0.68 and significant at the 1% level; the P/E Peer Group Year +1 is 0.31 andsignificant at the 5% level; the DFCF-coefficient is not significant. This again suggeststhat the preliminary offer price of IPOs which are valued with DFCF, DDM and P/EPeer Group Year +1, is primarily determined by DDM, and to a lesser extent by P/EPeer Group Year +1.

Column (2) of Table 8 reports regression results for 24 IPOs which were valuedwith DFCF and DDM. The preliminary offer price of these IPOs seems to be primarilydetermined by DDM, and to a lesser extent by DFCF. For 27 IPOs which were valuedwith DFCF and P/E Peer Group Year +1 (see column (3)), the underwriter seems torely primarily on DFCF, but also on P/E Peer Group Year +1. The results in column



Tab

le7

Pre-

IPO

Valu

eE

stim

ates

and

Prel

imin

ary

Off

erPr

ice:

APa

irw

ise

Com

pari

son

ofD

iffe

rent

Valu

atio

nM

etho

ds

Dis

coun

ted

Div

iden

dD

isco

unte

dP/

EPe

erD

ivid

end

P/E

Peer

P/E

Peer

P/E

Peer

Free

Cas

hD

isco

unt

Free

Cas

hG

roup

Dis

coun

tG

roup

Gro

upG

roup

Valu

atio

nM

etho

d:Fl

owM

odel

Flow

(yea

r+1

)M

odel

(yea

r+1

)(y

ear

0)(y

ear+1

)

Med

ian

13.8

%3.

4%15

.6%

11.2

%7.

7%11

.2%

−5.8

%8.

4%M

ean

12.9

%3.

2%15

.0%

7.4%

4.8%

7.4%

−38.

4%5.

7%St

anda

rdde

viat

ion

9.3%

8.7%

11.6

%14

.1%

9.2%

14.1

%13

1.7%

13.3

%In

terq

uart

ilera

nge

12.0

%12

.0%

18.5

%16

.8%

9.8%

13.6

%41

.3%

13.5

%

Perc

enta

gew

ithin

15%

62.5

%91

.7%

48.1

%63

.0%

84.6

%61

.5%

41.2

%70

.6%

Mea

nab

solu

teer

ror

13.7

%7.

9%15

.9%

13.9

%9.

1%13

.9%

51.6

%12

.6%

Num

ber

ofob

serv

atio

ns24

2427

2713

1317

17

Not

es:

Apa

irw

ise

com

pari

son

ofth

em

ost

com

mon

lyus

edm

etho

dsto

valu

e49

IPO

son

Eur

onex

tB

russ

els

betw

een

1993

and

2001

.Pr

icin

ger

rors

are

com

pute

das

the

natu

rall

ogof

the

ratio

ofth

ees

timat

edva

lue

toth

epr

elim

inar

yof

fer

pric

e.T

hepr

elim

inar

yof

fer

pric

eis

the

mid

poin

tof

the

min

imum

and

max

imum

offe

rpr

ices

,or,

ifth

esh

ares

are

not

offe

red

with

ina

pric

era

nge,

the

pre-

spec

ified

offe

rpr

ice.

The

pre-

IPO

valu

ees

timat

esar

epu

blis

hed

inth

eIP

O-p

rosp

ectu

s,w

hich

ism

ade

avai

labl

eat

the

star

tof

the

publ

icof

feri

ng.T

hefir

stfo

urro

ws

repo

rtm

edia

n,m

ean,

stan

dard

devi

atio

nan

din

terq

uart

ilera

nge

ofer

rors

.Tw

om

easu

res

ofva

luat

ion

accu

racy

are

repo

rted

:the

perc

enta

geof

erro

rsw

ithin

15%

,and

the

mea

nab

solu

teer

ror.

For

each

pair

ofva

luat

ion

met

hods

,the

num

ber

ofob

serv

atio

nsde

pend

son

the

num

ber

ofIP

Os

for

whi

chbo

thm

etho

dsar

eap

plie

d.



Table 8Relation of the Preliminary Offer Price to Pre-IPO Value Estimates

Explanatory Variables (1) (2) (3) (4)

C −0.37 −0.20 −0.12 0.50(−1.27) (−2.02)∗ (−1.58) (1.46)

Ln (DFCF estimate) 0.09 0.38 0.62 –(0.46) (2.36)∗∗ (4.94)∗∗∗

Ln (DDM estimate) 0.68 0.66 – –(3.15)∗∗∗ (3.82)∗∗∗

Ln (P/E Peer Group Year +1 estimate) 0.31 – 0.38 0.82(2.93)∗∗ (3.21)∗∗∗ (6.24)∗∗∗

Ln (P/E Peer Group Year 0 estimate) – – – 0.03(0.59)

Adjusted R2 0.95 0.99 0.99 0.96Number of observations: 13 24 27 17

Notes:OLS-regressions of the natural logarithm of the preliminary offer price on the natural logarithm ofvalue estimates by the lead underwriter, for 49 IPOs on Euronext Brussels between 1993 and 2001. Thepreliminary offer price is the midpoint of the minimum and maximum offer prices, or, if the shares are notoffered within a price range, the pre-specified offer price. The pre-IPO value estimates are published in theIPO-prospectus, which is made available at the start of the public offering. For each regression, the numberof observations depends on the number of IPOs for which the value estimates included in the regressionare used. t-values are reported in parentheses. ∗, ∗∗ and ∗∗∗ denote significant difference from zero at the10% level, the 5% level and the 1% level, respectively.

(4), based on 17 IPOs, suggest that when P/E Peer Group year 0 and year +1 are used,underwriters rely only on P/E Peer Group in year +1.13 Taken together, the regressionresults confirm those of the univariate analysis: the preliminary offer price seems tobe primarily determined by DDM, and underwriters rely more on forecasted multiplesthan on current multiples.

(b) Qualitative Analysis

In order to gain further insight into the way underwriters value and price IPOs, aqualitative analysis was carried out, by means of interviews with investment bankers,who were the lead underwriter of 45 of the 49 IPOs in our sample. They provideda consistent story on how Belgian IPOs are valued and priced. All seven investmentbankers consider DFCF the most important valuation method. DDM is regarded tobe too ‘conservative’ and is less relied on. One banker described DDM-valuation asmerely a control check on DFCF-valuation. Multiples, on the other hand, are drivenby market sentiment and may provide valuations that are ‘too high’ in a hot market(see for instance Fernandez, 2001). Glaum and Friedrich (2006) report that during thehigh market valuation period at the end of the 1990s analysts had to use comparativevaluation or even come up with new metrics like subscriber multiples for start-ups orhigh-tech stocks, to produce company values that were in line with concurrent stock

13 We did not estimate a separate regression for DDM and P/E Peer Group year +1, because the 13 IPOswhich were valued with DDM and P/E Peer Group year +1, were also valued with DFCF: see column (1).



prices.14 An offer price that is too high may severely damage the reputation of theunderwriter.

According to the investment bankers, the preliminary offer price and the offer pricerange are primarily determined by DFCF estimates, with DDM providing lower valueestimates and multiples providing higher value estimates. The preliminary offer priceis not actually based on a weighted sum of value estimates, but is set more loosely,taking into account the available value estimates (especially DFCF), and then applyinga price discount. The discount is required in order to ensure that the stock offersa good opportunity to investors and has upside potential, and that the issue will beoversubscribed. This guarantees a good deal to all parties involved in the transactionand ensures sufficient liquidity for the stock when trading begins. The final offer priceis the result of a negotiation between the issuer and the underwriter, and takes intoaccount relevant market circumstances.

This implies that our finding in the quantitative analysis that the preliminary offerprice is closest to DDM is not a consequence of underwriters primarily relying on DDM,but rather coincidentally as it tends to produce low valuations. The preliminary offerprice is closest to DDM because underwriters rely on valuation methods that producehigher value estimates, and apply a discount to these valuations.

The substantial difference between valuation according to DFCF and DDM isremarkable, as both valuation methods should yield the same value if consistentassumptions are made. Nevertheless, it is well recognized that dividend discountingtechniques are subject to some practical issues. In Penman and Sougiannis (1998),DDM produces considerably lower valuation results than DFCF. Francis, Olsson andOswald (2000) find that all their models underestimate value, but DDM to the largestextent. They state that models which should give the same results in theory, differin practice due to inconsistencies in forecasted attributes, growth rates and discountrates (e.g., clean surplus relationship violation, non-constant growth rates, discountrates inconsistent with no arbitrage principle, . . .). Lundholm and O’Keefe (2001)relate differences in the models to inconsistent forecast, inconsistent discount rateand missing cash flow errors. Damodaran (1994) explains the undervaluation of DDMbecause most practical valuation models do not allow (in an appropriate way) for thebuild-up in cash when firms pay out less than they are able to, which is often the case,and the use of incoherent assumptions. He claims that in reality, DFCF values oftenexceed DDM values.

Our interviews with the investment banks involved in the IPOs further shed somelight on the inconsistencies between the application of DFCF and DDM, and providean explanation why the latter often results in lower valuations. The investment banksare aware that DDM valuations in the prospectuses tend to be lower than the DFCFvaluations. One explanation they offer is that the DDM valuations do not take intoaccount the value of non-operating assets (such as excess cash). Moreover, many Belgiancompanies pay out only a fraction of their free cash flow as a dividend.15 As a result, mostof these companies are underlevered and overcapitalized. By consequence, if DDM is

14 In contrast to our expectations and as already reported, the multiple valuations in our sample weregenerally lower than the DFCF valuations. Results for the subsample of IPOs that went public during the hotmarket in 1997–1999 are qualitatively similar.15 In Belgium there is also a legal restriction that dividend payments cannot be higher than the net profitafter taxes.



based on actual dividends paid out, it will on average produce lower valuations thanDFCF, which assumes that all free cash flows are returned to the investors when theyare available.

Another explanation put forward by the investment banks is that companies typicallygo public when they need funds for large investments. This results at first in lowdividend payouts, but leads to a high dividend growth later on. Often, the terminal(or continuing) value estimates used in the DDM model are too pessimistic, as thepayout is not set at a level reflecting that the current high growth will slow down,and that less financial resources will be needed for new investments. In other words,this is an example of an inconsistent adjustment of the payout ratio and the growthrate.

Most investment banks prefer the DFCF method as it considers the overall picture.The DDM, on the other hand, produces an all-in-one value for the shareholder.Although the investment banks are aware of most of the above inconsistencies, theydo not really attempt to reconcile both methods, since the majority of investors attachlittle importance to the DDM-outcome; most only care about DFCF and multiples. Block(1999) argues that a firm’s dividend policy (and thus the DDM) is relatively unimportantin a financial analyst’s analytical process, due to the irrelevance of dividends theory ofModigliani and Miller (1961), the fact that dividends do not count for much in ananalyst’s mind when annual returns are 20–30% as in the late nineties, and the desireof corporations to buy back shares rather than increase cash dividends.

(iii) The Performance of Valuation Models

In this section, we investigate the performance of the valuation models. Section5(iii)(a) investigates the bias and accuracy of valuation models. In Section 5(iii)(b),we investigate whether the final offer price is closer to the stock market price than thepre-IPO value estimates.

(a) The Bias and Accuracy of Valuation Models

Results on the bias and accuracy of the valuation methods are presented in Table 9.Results based on the stock price on post-IPO days +1, +10, +20 and +30 are verysimilar and are therefore not reported in the paper. DFCF seems to be an unbiasedvalue estimator: the median valuation error is only 4.6% and not significant (Wilcoxonsigned rank test p = 0.681). DDM on the other hand produces biased estimates ofvalue: the median valuation error is −10.6% and is significant (p = 0.006). If thestock market prices IPOs correctly, then DDM tends to underestimate value. For mostmultiple valuation methods, we also find a negative median valuation error, but thiserror is significant at the 10% level or higher for only three methods: P/E Peer Group(year 0) (p-value = 0.082), P/E Stock Market (year 0) (p-value = 0.009) and P/CF StockMarket (year +1) (p-value = 0.031). For P/E Peer Group (year +1) and P/CF PeerGroup (year +1) the median valuation error is not significantly different from zero,which suggests that these multiples provide unbiased value estimates. Of course, formost multiples the sample is very small, which affects the quality of statistical testing.

Again, we use the percentage within 15% and the mean absolute error to measurethe accuracy of the valuation methods. The results suggest that DFCF, DDM and themost commonly used multiples (P/E Peer Group year 0 and year +1) have similar



Tab

le9

Pre-

IPO

Valu

eE

stim

ates

and

Stoc

kPr

ice:

AC

ompa

riso

nof

Dif

fere

ntVa

luat

ion

Met

hods

Dis

coun

ted

Div

iden

dP/

EPe

erP/

EPe

erP/

ESt

ock

P/E

Stoc

kP/

CF

Peer

P/C

FPe

erP/

CF

Stoc

kP/

CF

Stoc

kFr

eeC

ash

Dis

coun

tG

roup

Gro

upM

arke

tM

arke

tG

roup

Gro

upM

arke

tM

arke

tVa

luat

ion

Met

hod:

Flow

Mod

el(y

ear

0)(y

ear+1

)(y

ear

0)(y

ear+1

)(y

ear

0)(y

ear+1

)(y

ear

0)(y

ear+1

)

Med

ian

4.6%

−10.

6%−9

.3%

−4.3

%−2

3.7%

−5.0

%4.

6%−1

.3%

−27.

3%−2

0.4%

Mea

n0.

0%−1

6.0%

−45.

0%−1

1.9%

−33.

4%−1

1.4%

14.7

%8.

0%−2

4.9%

−20.

5%St

anda

rdde

viat

ion

30.5

%28

.6%

123.

5%30

.7%

34.8

%34

.8%

36.1

%32

.9%

30.8

%9.

6%In

terq

uart

ilera

nge

30.0

%22

.2%

54.8

%36

.0%

46.3

%35

.4%

29.6

%27

.6%

22.3

%11

.1%

Perc

enta

gew

ithin

15%

46.9

%50

.0%

38.1

%48

.2%

33.3

%41

.7%

50.0

%66

.7%

0.0%

33.3

%M

ean

abso

lute

erro

r21

.6%

22.3

%58

.1%

23.9

%36

.7%

27.1

%25

.4%

21.2

%35

.9%

20.5

%

Num

ber

ofob

serv

atio

ns49

2421

2712

1212

128

6

Not

es:

Aco

mpa

riso

nof

the

mos

tco

mm

only

used

met

hods

tova

lue

49IP

Os

onE

uron

ext

Bru

ssel

sbe

twee

n19

93an

d20

01.

Valu

atio

ner

rors

are

com

pute

das

the

natu

rall

ogof

the

ratio

ofth

ees

timat

edva

lue

toth

eav

erag

est

ock

pric

ein

the

first

mon

thof

listin

g.T

hepr

e-IP

Ova

lue

estim

ates

are

publ

ishe

din

the

IPO

-pro

spec

tus,

whi

chis

mad

eav

aila

ble

atth

est

arto

fthe

publ

icof

feri

ng.T

hefir

stfo

urro

wsr

epor

tmed

ian,

mea

n,st

anda

rdde

viat

ion

and

inte

rqua

rtile

rang

eof

erro

rs.T

wo

mea

sure

sof

valu

atio

nac

cura

cyar

ere

port

ed:t

hepe

rcen

tage

ofer

rors

with

in15

%,a

ndth

em

ean

abso

lute

erro

r.Fo

rea

chva

luat

ion

met

hod,

the

num

ber

ofob

serv

atio

nsde

pend

son

the

num

ber

ofIP

Os

for

whi

chth

em

etho

dis

appl

ied.



accuracy. For each of these methods, about half of the valuations is within 15% of theaverage stock price in the first month of listing. The mean absolute errors are also verysimilar: they are not significantly different from each other, except the mean absoluteerror of P/E Peer Group year 0, which is significantly larger than DFCF mean absoluteerror (p-value = 0.043).

It is interesting to compare our results on value accuracy with the valuation accuraciesobtained by Kim and Ritter (1999), who investigate the value accuracy of multiples usinga sample of 190 US IPOs from 1992 to 1993. They use recent IPOs as comparables, whichare chosen with a mechanical algorithm, and comparables chosen by a firm specializingin IPO research. Comparing IPO multiples to the median comparables multiple and apredicted multiple using regressions, they find much lower valuation accuracy than wedo. It may seem surprising that objective valuations by academics are less accurate thanvaluations by lead underwriters. As we have noted in the introduction, value estimatesby lead underwriters may be more accurate because they often have better access toinformation that is useful for valuation. Moreover, the lead underwriter may be affectedby the market mood at the time of valuation. On the other hand, the post-IPO stockprice may be affected by the valuation of the lead underwriter, if the market is willingto be guided by the valuations made at the pre-IPO stage. In that case, the valuationinfluences the market, rather than the other way around. The Belgian IPOs in oursample are also often mature firms that are comparatively easy to value. Finally, it canbe expected that lead underwriters choose to report only valuation results that areappropriate for the type of firm that needs to be valued, while academics report allestimates of the valuation method(s) they investigate.

When we compare the valuation accuracy of the different multiples approaches inTable 9, it is striking that the valuations based on the forecasted earnings and cash flowsin year +1 are consistently less biased and more accurate than the valuations based onthe forecasted current year’s earnings and cash flows: this result holds for both theP/E and the P/CF peer group multiples, and for the P/E and the P/CF stock marketmultiples, for all measures of valuation accuracy.16

Another interesting result is the quite good performance of the P/CF Peer Group(year +1) multiple: compared to the other valuation methods it has the lowest medianvaluation error and the highest percentage within 15%. A possible explanation forthis result might be that P/CF is mainly used by underwriters to value firms which arerelatively easy to value: older and larger firms with low growth prospects and a highdividend payout (cf. Table 5).

Again, we make a pairwise comparison of valuation methods: DFCF, DDM and P/Ebased on a peer group for year +1 are mutually compared, as well as P/E based on apeer group in year 0 and year +1. The results, which are presented in Table 10, confirmthose of Table 9.17

Given the dissimilar characteristics of firms that seek listing on the First and NewMarket, there might be a divergence in the frequency of use and performance ofalternative valuation models across both groups of firms. Panel A of Table 11 reports

16 This result is further confirmed if we take into account valuations based on the earnings and cash flowsin years –1 and +2. We did not include these valuations in Table 9 because they are based on a very limitednumber of observations (1 to 5 observations).17 We also compared P/CF Peer Group (year +1) pairwise with DFCF, DDM and P/E Peer Group(year +1). The results (unreported but available from the authors upon request) also confirm those ofTable 9.



Tab

le10

Pre-

IPO

Valu

eE

stim

ates

and

Stoc

kPr

ice:

APa

irw

ise

Com

pari

son

ofD

iffe

rent

Valu

atio

nM

etho

ds

Dis

coun

ted

Div

iden

dD

isco

unte

dP/

EPe

erD

ivid

end

P/E

Peer

P/E

Peer

P/E

Peer

Free

Cas

hD

isco

unt

Free

Cas

hG

roup

Dis

coun

tG

roup

Gro

upG

roup

Valu

atio

nM

etho

d:Fl

owM

odel

Flow

(yea

r+1

)M

odel

(yea

r+1

)(y

ear

0)(y

ear+1

)

Med

ian

0.3%

−10.

6%4.

6%−4

.3%

−16.

1%−4

.3%

−18.

5%−4

.3%

Mea

n−6

.3%

−16.

0%−4

.3%

−11.

9%−2

3.6%

−21.

0%−5

9.4%

−15.

3%St

anda

rdde

viat

ion

30.8

%28

.6%

30.2

%30

.7%

32.6

%38

.2%

132.

9%31

.5%

Inte

rqua

rtile

rang

e31

.1%

22.2

%27

.4%

36.0

%35

.2%

72.0

%67

.8%

34.2

%

Perc

enta

gew

ithin

15%

50.0

%50

.0%

51.9

%48

.2%

46.1

%46

.1%

35.3

%52

.9%

Mea

nab

solu

teer

ror

21.5

%22

.3%

20.4

%23

.9%

26.3

%32

.2%

66.8

%24

.1%

Num

ber

ofob

serv

atio

ns24

2427

2713

1317

17

Not

es:

Apa

irw

ise

com

pari

son

ofth

em

ost

com

mon

lyus

edm

etho

dsto

valu

e49

IPO

son

Eur

onex

tB

russ

els

betw

een

1993

and

2001

.Va

luat

ion

erro

rsar

eco

mpu

ted

asth

ena

tura

llo

gof

the

ratio

ofth

ees

timat

edva

lue

toth

eav

erag

est

ock

pric

ein

the

first

mon

thof

listin

g.T

hepr

e-IP

Ova

lue

estim

ates

are

publ

ishe

din

the

IPO

-pro

spec

tus,

whi

chis

mad

eav

aila

ble

atth

est

art

ofth

epu

blic

offe

ring

.The

first

four

row

sre

port

med

ian,

mea

n,st

anda

rdde

viat

ion

and

inte

rqua

rtile

rang

eof

erro

rs.T

wo

mea

sure

sof

valu

atio

nac

cura

cyar

ere

port

ed:t

hepe

rcen

tage

ofer

rors

with

in15

%,a

ndth

em

ean

abso

lute

erro

r.Fo

rea

chpa

irof

valu

atio

nm

etho

ds,t

henu

mbe

rof

obse

rvat

ions

depe

nds

onth

enu

mbe

rof

IPO

sfo

rw

hich

both

met

hods

are

appl

ied.



Table 11First Market versus New Market

Panel A: Valuation Methods UsedVariable First Market (34 IPOs) New Market (15 IPOs)

Discounted Free Cash Flow 34 15Dividend Discount Model 23 1P/E Peer Group (year 0) 19 2P/E Peer Group (year +1) 20 7P/E Stock Market (year 0) 11 1P/E Stock Market (year +1) 11 1P/CF Peer Group (year 0) 12 0P/CF Peer Group (year +1) 12 0P/CF Stock Market (year 0) 8 0P/CF Stock Market (year +1) 6 0Median number of methods used 4 2

Panel B: Pre-IPO Value Estimates and Stock PriceDiscounted Free Cash Flow P/E Peer Group (year +1)

Valuation Method:First Market New Market First Market New Market

Median 0.98% 15.72% −5.42% 13.88%Mean −6.28% 15.56% −16.39% 1.02%Percentage within 15% 50.00% 40.00% 50.00% 42.86%Mean absolute error 19.92% 25.39% 25.36% 19.68%

Notes:Panel A: The number of IPOs for which the IPO-prospectus provides a value estimation based on aparticular valuation method.Panel B: The reported valuation errors are computed as the natural log of the ratio of the estimated valueto the average stock price in the first month of listing.

the valuation methods used to value IPOs on the First and New Market. There areindeed some differences between both markets. The median IPO on the First Marketis valued with four methods while the median IPO on the New Market is valued withDFCF and only one other method, which is typically P/E Peer Group (year +1).Thus, underwriters use primarily valuation models based on forecasted amounts ofcash flows or earnings for valuing New Market IPOs. Yet, it is more difficult to makeforecasts for these young high growth technology firms. This finding reveals a degreeof sophistication in the valuation model choice of underwriters. A possible explanationis that New Market IPOs do not have sustainable current earnings or cash flows to beused as measures of future value. Table 11 also confirms our finding in Table 5 thatyoung high growth firms, which are generally introduced on the New Market, are notvalued with DDM or P/CF.

Panel B reports valuation errors for the two methods which are frequently used forvaluation on the New Market: DFCF and P/E Peer Group (year +1). For New MarketIPOs, the median DFCF valuation error is quite high at 15.72%, while for First MarketIPOs it is close to zero. The difference between the New and First Market is significantat the 5% level. This suggests that DFCF tends to overestimate the stock market valueof IPOs on the New Market, which usually involve young and small high growth firms.On the other hand, we do not find a significant difference in the accuracy of DFCF



measured by the mean absolute valuation error between the New and First Market.As for the P/E Peer Group (year +1) multiple, Panel B of Table 11 reports highermean and median valuation errors for the New Market than for the First Market, butthe differences are not statistically significant. The mean absolute error is also notsignificantly different between First and New Market IPOs.

(b) Pre-IPO Value Estimates and the Final Offer Price

During the public offering period, the underwriter obtains information about investordemand and updates the price. In addition, the bank may incorporate any changesin general market conditions, industry or firm-specific outlooks. The final offer priceshould therefore be a more accurate predictor of the stock price than the estimatesof individual valuation methods. To test whether this is indeed the case, we comparethe relation between the final offer price and the stock price on the one hand, to therelation between the estimated value and the average stock price in the first monthof listing on the other hand. For each valuation approach, the offer price should becloser to the stock price than the value estimate if the lead underwriter also uses othervaluable information to determine the price at which the shares will be offered. Resultsfor the most commonly used valuation methods are presented in Table 12. The numberof observations for each valuation method depends on the number of IPOs which wereinitially offered within a price range (not at a unique offer price), and which werevalued with this estimation method.

For the 33 firms that are valued using DFCF, 15 firms (45.4%) have a DFCF estimatedvalue within 15% of the stock price, while 19 firms (57.6%) have an offer price within15% of the stock price. For the 21 firms that are valued using DDM, 10 firms (47.6%)have a DDM estimated value within 15% of the stock price, while 14 firms (66.7%) have

Table 12Pre-IPO Value Estimates, Stock Price, and Final Offer Price: A Comparison of

Different Valuation Methods

Discounted Free Dividend P/E Peer P/E PeerValuation Method: Cash Flow Discount Model Group (year 0) Group (year +1)

Ln (estimated value/average stock price in the first month of listing)Percentage within 15% 45.4% 47.6% 38.9% 50.0%Mean absolute error 22.1% 23.4% 34.4% 25.4%

Ln (offer price/average stock price in the first month of listing)Percentage within 15% 57.6% 66.7% 61.1% 55.0%Mean absolute error 21.3% 20.4% 20.9% 22.1%

Number of observations 33 21 18 20

Notes:A comparison of the most commonly used methods to value 49 IPOs on Euronext Brussels between1993 and 2001. Valuation errors are computed as the natural log of the ratio of the estimated value tothe average stock price in the first month of listing, and as the natural log of the ratio of the final offerprice to the average stock price in the first month of listing. The pre-IPO value estimates are published inthe IPO-prospectus, which is made available at the start of the public offering. Two measures of valuationaccuracy are reported: the percentage of errors within 15%, and the mean absolute error. For each valuationmethod, the number of observations depends on (a) the number of IPOs which were initially offeredwithin a price range (not at a unique offer price), and (b) the number of IPOs which were valued with thisestimation method.



an offer price within 15% of the stock price. A comparison of mean absolute errors alsosuggests that the offer price is closer to the stock price than the DFCF and/or DDM valueestimates. However, the differences in the mean absolute errors are never statisticallysignificant. Finally, the results for the most commonly used multiple estimates indicatethat the offer price is closer to the stock price than the multiple estimates, but again,the differences in the mean absolute errors are not statistically significant.18

6. VALUATION AND UNDERPRICING

Probably the most often researched anomaly in the IPO market concerns underpricingand high average initial returns. These are found over a wide range of time periods andcountries. (see e.g., Ibbotson and Ritter, 1995; and Ritter, 2003, for an overview of theevidence). Ritter and Welch (2002) find an average initial return on the first tradingday of 18.8% in their sample of US firms going public from 1980 to 2001. In our sample,the initial return averaged 19.3%, which is a strong indication of underpricing.

In the context of our paper, underpricing could be consistent with three differentexplanations. First, underwriters may rely on DDM because they believe that DDMproduces the most accurate value estimates, not realizing that DDM tends to under-estimate value. Alternatively, underwriters may consciously underprice the IPO, byrelying on DDM. Third, underwriters may deliberately underprice the IPO by applyinga discount to other value estimates (such as DFCF), or to a weighted average ofvaluations. Given the results in Section 5(ii) (preliminary offer price is on averageclosest to DDM estimates, but underwriters rely on DFCF estimates applying a discountto it) and the results in Section 5(iii) (DDM tends to underestimate value while DFCFis an unbiased value estimator), the third explanation should be retained, in thatunderwriters consciously underprice the IPO by applying a discount to the DFCFestimates.

The hypothesis that underwriters consciously underprice IPOs is further supportedby the fact that for 21 out of 24 IPOs for which both DDM and DFCF were used, theDDM valuation, which is on average closest to the preliminary offer price, was lowerthan the DFCF valuation. For only one IPO, DDM and DFCF lead to the same valueestimate.

Another indication that underwriters consciously underprice the IPO is that for 14 ofthe 49 IPOs, the preliminary offer price was set lower than all value estimates publishedin the prospectus. An example is the IPO of Real Software, a Belgian software company:DFCF, minimum multiple and maximum multiple estimates were respectively 21.8%,48.1% and 50.0% higher than the preliminary offer price. The average stock price ofReal Software in the first month of listing was 64.6% higher than the preliminary offerprice.

7. CONCLUSIONS

While literature on IPOs is abundant and several studies investigate the accuracy ofvaluation approaches, very few studies have investigated the valuation of IPOs byunderwriting investment banks. We investigate the valuation by the lead underwritersof 49 IPOs on Euronext Brussels in the 1993–2001 period. We find that the lead

18 P -values are 0.89 for DFCF, 0.69 for DDM, 0.18 for P/E Peer Group (year 0), and 0.70 for P/CF PeerGroup (year +1).



underwriter always uses several valuation approaches, of which DFCF is the mostpopular. This is in sharp contrast to the standard literature on valuation model choice,which typically finds that multiples are much more often used than present valuetechniques. Our analyses show that DDM tends to underestimate value, while DFCFproduces unbiased value estimates. However, DDM, DFCF and the most commonlyused multiples have similar accuracy. Interviews with investment bankers suggest thatunderwriters consciously underprice IPOs, by applying a deliberate discount to DFCFvalue estimates. DFCF is considered to be the most reliable method. DDM estimatesare on average closer to the preliminary offer price than other value estimates, becauseDDM tends to underestimate value.

When multiples valuation is used, investment banks rely mostly on forecasted futureearnings and cash flows. We find that multiples valuation based on post-IPO forecastedearnings and cash flows indeed leads to more accurate valuations than multiplesvaluation based on earnings and cash flows in the IPO-year. Our results also indicatethat the IPO final offer price is closer to the post-IPO stock price than pre-IPO valueestimates, which is consistent with the lead underwriter using not only value estimatesbut also other valuable information to set the final offer price.

Our findings offer some important insights into the valuation of IPOs and theaccuracy of valuation methods. The results suggest that discounted cash flow modelsare not superior (or inferior) to multiple valuation models when applied in the realworld. However, we do find DDM has a tendency to underestimate value. Yet, DFCF andeven DDM models are commonly used by investment bankers, which seem to have moretrust in DFCF than in multiples or DDM. This paper also confirms that underwritersconsciously underprice IPOs by applying a discount to their estimated value.

We identify various directions for future research. It would be interesting to examinewhat valuation methods investment banks use and how accurate underwriters are inpredicting the stock market prices in countries such as the US, the UK and Japan.Another attractive research avenue would be to investigate how IPO firm or dealspecific variables affect valuation accuracy. For instance, one could study whether largerventure capital backed firms taken public by a reputable underwriter are valued withgreater accuracy. Such research would provide further insights in the motives of IPOunderwriters and in the characteristics of IPOs. Finally, studies about both the use andaccuracy of valuation methods should be conducted in related contexts like privateequity investments and M&A.

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