Bangladesh Securities and Exchange Commission (BSEC) has issued a new directive on February 1, 2021, about the methods that Eligible Institutional (EI) investors should use in determining the fair value of Initial Public Offering (IPO) stock. BSEC has come up with new methods because stocks floated following the existing methods are found to be over-valued in the IPO.
As a student of finance, this scribe finds these methods inadequate and susceptible to manipulation again.
The new method says that institutional investors can now bid only up to 20 per cent higher or 1.2 times the fair value of primary shares, and there will be no lower limit for bidding. How does the new directive determine fair value? As per the directive, fair value is the simple average of (1) net asset value (NAV) and (2) value obtained by the earnings yield method (EYM).
First, the BSEC directive does not define whether NAV should be at historical costs or at market value (with revaluation) and whether NAV should be based on pre-IPO shares or post-IPO shares. Moreover, NAV varies widely across the industry. For example, by default financial industries such as banks, non-bank financial institutions (NBFIs), or heavy capital intensive industries such as engineering, textile will have high NAV because of their business model. Such high NAV does not have anything to do with future profit potentials. Similarly, companies that do business based on technology, reliability, or that requires high marketing and product development costs will have very low NAV. Relating NAV with fair value in such a crude method will encourage bad performing companies with high NAV to come to market and discourage good performing companies with low NAV to stay away from the market.
Second, the BSEC directive introduced a new method of fair pricing in public issue rule 2015- Earning Yield Method. According to this method, the company's expected rate of earnings will be divided by its actual rate of earnings and then the product will be multiplied by the paid-up value that includes its share premium. The normal rate of earnings will have to be at least 10.0 per cent of the paid-up value. This method requires a simple explanation.
For example, suppose a company's net profit after tax is Tk 100, Tk 120, Tk 140, Tk 160 and Tk 180 for 2016, 2017, 2018, 2019 and 2020 respectively. Its paid-up capital is Tk 1200 and share premium is Tk 100. According to this method, the expected rate of earning is Tk 140 (100+120+140+160+180) and paid up capital and share premium is Tk 1300 (1200+100). So expected yield is 140/1300 = 10.77 per cent. The directive says that normal rate of earning should be 10 per cent or more. Given the ambiguity of this definition, every institutional investor may take 10 per cent as the normal rate of earning. Now, according to this method, fair value would be -expected earnings yield/normal rate of return*par value or (10.77%/10%)*100 = 10.77 per share.
So, if the value according to NAV is 11 and the value according to EYM (calculated above) is 10.77, the fair value would be 11+10.77 = 10.88 per share. Institutional investors can now bid only up to 20.0 per cent higher or 1.2 times the fair value of primary shares which is 10.88*1.2 =13.06 per share at maximum and there will not be any lower limit.
Now notice the EYM. The EYM does not take into consideration the risk of business or earnings (credit rating), respective firm's size, the impact of post-IPO capital on the rate of profitability. EYM is totally based on past earnings and firms considering IPO might easily boost up their net profit after tax in the pre-IPO period by non-recurring business activity ( sale of land or other assets, timing their expense, and revenue recognition). Moreover, if there is any significant change in business that might result in future operation, it will not be reflected in the EYM. Furthermore, the definition, EYM is itself inadequate because it does not mention what would be the base of expected earning yield; whether pre-IPO share capital or post-IPO share capital or average of last five years.
Most importantly, the stock value reflects the future earning potentials, not what happened in the past. What happened in the last five years is relevant but that relevance has its limitations which can be overcome by incorporating its future earning potentials, management quality, and risk of the business. It seems that BSEC's good intentioned-directive to find the fair value of the IPO stock is unlikely to serve the purpose of determining the firm's true intrinsic value because no one can imprison the science of equity research into the formula of net asset value (NAV) and earning yield method (EYM).
Md Sajib Hossain, CFA is a Fulbright Scholar at Syracuse University, USA and Assistant Professor of Finance, University of Dhaka