How do investment bankers set the price on a new public stock offering (IPO)?

When Bill Gates III wanted to cash in on all the work and effort he put into Microsoft, the computer software company he founded, he took advantage of something called an initial public offering, or IPO. Today the thirty-five-year-old Harvard dropout is worth $3.9 billion.

What is an IPO and how does it work? An IPO is a corporation’s first offering of stock to the public. It is also almost invariably an opportunity for the existing investors and participating venture capitalists to make big profits, since for the first time their shares will be given a market value reflecting expectations for the company’s future growth.

When a private company decides to sell shares to the public, it usually hires an investment banking firm, such as Morgan Stanley or Goldman Sachs. This firm assumes the risk of buying the new securities from the corporation at a fixed price and selling them to the public at a markup, the markup representing the firm’s profit. The investment banking firm often diffuses the risk among a number of other underwriters called a syndicate.

Determining the share price of a new issue is tricky business. The company and its investment banker often use a Wall Street formula called a price-earnings ratio, or P/E, which is the price of a stock divided by its earnings per share. A company, for instance, whose stock was selling for $20 a share and had annual earnings of $1 a share would have a P/E of 20.

In layman’s terms, the P/E indicates how much investors might be willing to pay for a company’s earning power. A stock going public with a high P/E means the company going public has good future earnings potential. High P/E stocks, those with P/Es over 20, are typically young, fast-growing companies. Low P/E stocks are quite the opposite and tend to be in mature industries or sectors of the economy that have fallen out of favor with investors.

Setting the IPO price involves a lot of guesswork on the part of the investment banker. If the investment banker believes that investors will perceive the company as a rising star, he will set a price with a high P/E. If he thinks investors will be only lukewarm about the company’s future earnings potential, he’ll have to consider a lower P/E and thus a lower stock price.

If, for example, a hot, young biotechnology firm with high earnings potential is going public, investment bankers would argue that the stock deserves a high P/E. If they expect the stock to earn, say 50 cents a share next year, they might set the share price at $15, or a P/E of 30. For the investor, that’s only about a 3 percent return on each share of stock. But if the company’s earnings keep growing quickly in the years to come, that high price may be well worth it.

Private companies like to go public when the stock market is doing well. That way they’ll be able to raise more money for each dollar of projected earnings. If, however, the market is in a slump, companies usually wait to go public until a bull market returns.

Once a company decides to go public, it’s the underwriters who take most of the risk. That’s because the underwriters make the profit on the difference between the price they pay to the issuer for the new stock and the public offering price. When there’s strong demand for an IPO, the underwriter will sell all the new stock and make a handsome profit.

But if there’s weak demand for the stock, perhaps the price was set too high, then the underwriters are stuck with stock worth less than what they paid for it.