After the last issue on stock markets, we will see how a company becomes public. A public company is different from a Public Sector Unit (PSU). Any company in which the general public can buy a part of its ownership(stocks) is called a public company. Any company in which government has more than 50% ownership is a PSU. Once a company becomes public, all its financial figures are also in public domain and government or regulatory bodies like SEBI can take steps to protect investor interest.
Let us take the case of a medium-sized IT company making a net profit of Rs.50 crore every year. It may want to become a public company because many clients would like to have business with a publicily-listed company (their stability is publicily known), or it may need to raise a large amount of money (the other option of taking a loan from a bank involves heavy interest), or it may just want to share its profits with its employees. The company informs the regulator(SEBI) that it wants to raise money from the public and will be listed in the stock exchange. Once SEBI gives its approval, the company can start the process of the Initial Public Offer, or the IPO.
First, the company needs to decide on how much of its ownership it is willing to make public. Current Indian laws demand atleast 25% to be made public. Note that the original owners (called promoters) can (and usually will) retain the majority control of the company as long as they hold above 50% of the stake. Let us say our company wants to sell 25% of its stake to the public.
The company also needs to decide on the number of shares. Let us say it is 1 crore – so out of it, 25 lakh (25%) shares will be sold to the public. As you will see shortly, having a small number of shares (remember 1 crore is pretty “normal”) drives up the price of each share, and many investors might be unwilling to deal with it. Having a large number of shares make the price too low, making it appear cheap.
Now, since it is making Rs.50 crores as net profit per year and there will be 1 crore shares total, the earnings per share (EPS) is Rs.50. Now, one of the most important terms in stock markets is PE, which is the ratio of Price per share to Earnings per share. The average PE of an industry sector in a “stable” economic scenario is well researched. For heavy industries (like oil, iron and steel), it is around 10-15. For fast-growing sectors (like IT), it is around 20-30. We will suppose our IT company is a fast-growing one and assume a PE of 25. Since EPS is Rs.50 and PE is 25, we will see that the Price per share is 25*50= Rs.1250.
So the company can price its IPO around this price. Since there are 25 lakh shares avilable in the IPO, the company will raise Rs.1250*25 lakhs = Rs.312.5 crore. That is a lot of cash, which it can use to invest in new infrastructure or buy out other companies.
It is for the company to decide the price – there are no legal limits. If it raises the IPO issue price too much, it will get more cash. The risk is that, in such a case, the PE might be very high and many investors might be unwilling to invest. If there are not enough buyers (undersubscribed IPO), it is a big blow to the image of a growing company, even if the promoters themselves can invest to cover the deficit. On the other hand, if the issue price is made lower, the company is losing cash since there would have been buyers even at a higher rate. The company and its bankers will have to arrive at an optimal pricing to ensure it gets maximum cash and it is subscribed fully.
Once the IPO is listed, the company no longer gets any cash from the market – the trading is being done between the buyers and sellers in the stock market, as we will see in the next issue.