What is an IPO? How and why do companies go public? A guide to how initial public offerings work.
What is an IPO? Answering this question is crucial for those approaching the world of finance.
IPO refers to the listing of companies on the stock exchange and it is possible to make good profits from it, if you can understand how it works.
The IPO market has experienced difficult years and has recovered in 2024. In the last two years, in fact, due to difficult macroeconomic conditions, including high interest rates, geopolitical risks and general market instability, initial public offerings have come to a halt. With recent interest rate cuts and some clarity following the inauguration of the new US administration, IPO activity is set to pick up in 2025.
Last October, for example, saw the busiest week in terms of IPO activity since 2021. Increased investor confidence, expected deregulation, and ongoing market stability will likely act as catalysts for a boom in activity, even if the path of Fed rates and Trump’s tariffs remain unknown.
The IPO, however, is a key component of the financial market. Here is a guide to understanding how it is structured and why companies decide to go public.
What is an IPO?
The term IPO refers to the moment in which a company intends to be listed on the stock market by offering its own shares. There are 2 types of public offerings:
- Public subscription offer (OPS): this is the case in which the company issues new shares on the market when it is listed;
- Public sale offer (OPV): this indicates the case in which the issuing company sells a portion of its shares to the market;
- A third case (OPVS) is a mix of the two types of offerings but is rarer than the other 2 cases.
The difference between OPS and OPV essentially lies in the proceeds generated for the company.
In the case of OPS, the placement corresponds to a capital increase, thus generating cash flows for the company to be listed on the stock exchange.
In the OPV, however, the proceeds generated are not for the company, but are only available to the owner or owners of the company since they correspond to a deed of sale.
IPO: what are the benefits of a listing on the stock exchange
The benefits of a listing on the stock exchange are varied and touch on different areas such as tax, financial and operational. In particular, these advantages are generated:
- guarantee of debt reduction making access to risk capital easier;
- the listed stock may be used for future strategic activities of the company such as mergers and acquisitions;
- entry of institutional shareholders into the company capital;
- use of the stock to incentivize company performance through stock option plans for management and employee participation in the share capital through the transfer of shares;
- improvement of the company’s internal information flows to meet the information requirements to be disclosed to the market;
- tax incentives arising from listing on the stock exchange.
Benefits that certainly cannot be overlooked or not taken into serious consideration when talking about investments and placement on the stock exchange.
The phases of IPO price formation and placement on the market
The most used methodologies for placement on the stock exchange are 3: book building, auction and fixed price offer.
In particular, the book building method is the most used and involves the formation of the price range through the use of the demand expressed by institutional investors.
The company, after having made the decision to list on the stock exchange, looks for one or more intermediaries who will handle the placement. These intermediaries will handle the management of the IPO, sponsoring the company, certifying the stock exchange requirements and promoting the IPO on the market. Common practice is for the placing intermediary to be able to take possession of a more or less significant portion of the shares.
IPO: pay attention to the valuation
The most complex phase of the IPO is the valuation of the company to decide the price range to propose to the market. During this step, different valuation methodologies can be adopted.
The most used is the income method, which estimates future cash flows and operating income by discounting them. The equity method or the market multiples method can also be used.
The first method is used in cases where the company is easy to value. The second, on the other hand, is used to compare the multiples of companies similar to the one being listed that are already present on the market, allowing for a comparative valuation.
After having carried out the valuation, the Information Prospectus is issued, which lists the details of the offer, the accounting data and the future prospects of the company.
Once the price range of the offer has been identified, the price of the listing will be chosen through the book building analysis. In this way, the final price will be decided from the price range based on the subscription demand. The price decision generally occurs at the end of the placement operation.
Once the listing price has been identified and subsequently disclosed to the market, the stock is ready to enter the market on the pre-established day of opening of trading.
On the day of opening of trading of the stock, it may happen that the price rises because the market deems it low compared to the real valuation of the company, or that the price undergoes a contraction despite the great demand, until the market has defined the real value of the company.
Original article published on Money.it Italy. Original title: IPO, cos’è e come funziona l’offerta pubblica iniziale in Borsa
