The impact of fundamentals on IPO valuation.

We examine how initial public offering (IPO) valuation has changed over time by focusing on three time periods: 1986-1990, January 1997 to March 2000 (designated as the boom period), and April 2000 to December 2001 (designated as the crash period). Using a sample of 1,655 IPOs, we find that firms with more negative earnings have higher valuations than do firms with less negative earnings and firms with more positive earnings have higher valuations than firms with less positive earnings. Our results suggest that negative earnings are a proxy for growth opportunities for Internet firms and that such growth options are a significant component of IPO firm value.

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Valuation of initial public offerings (IPOs) occupies an important place in finance, perhaps because an IPO provides public capital market participants their first opportunity to value a set of corporate assets. Valuation of IPOs is also quite relevant from an economic efficiency perspective; the IPO is the first opportunity that managers of such (usually young) companies get to observe price signals from the public capital markets. Such signals can either affirm or repudiate management's beliefs regarding the firm's future growth opportunities, which have obvious implications for real economic activity (i.e., employment and corporate investment).

The valuation of IPOs in the late 1990s has generated significant interest in the popular press in addition to the financial press. Part of the reason for the popular interest in IPO valuation in the late 1990s was the public's interest in the "new e-conomy." In the latter half of 1990s, the stock market experienced unprecedented gains, powered by technology and Internet companies (see Ofek and Richardson, 2003). These enormous price surges caused several commentators to raise questions about whether traditional valuation methods remained valid in this period. McCarthy (1999) reports an example of this concern in a statement by Jerry Kennelly, Chief Financial Officer of Inktomi, "Early profitability is not the key to value in a company like this." Such claims were more common in the context of IPOs. For example, Gove (2000) remarks, "But valuations are just as often based on gut feel. As one entrepreneur told me, 'It's as if everybody just settles on a number that they are comfortable with.'"

In this study, we examine whether, and to what extent, there were shifts in the valuation of IPOs in the new economy period. We consider the valuation of a sample of 1,655 IPOs during two distinct periods: 1986-1990 (hereafter, the 1980s), and 1997-2001. The choice of two distinct periods for our study is motivated by our interest in understanding IPO valuation in the new economy. This new economy has a temporal and industry characterization to it. During the late 1990s, technology companies, especially those with an Internet focus, were in the vanguard of this new economy. Examining IPOs during 1986-1990 allows us to construct a baseline "traditional" IPO valuation model. The variables we include in our model are income, book value of equity, sales, research and development (R&D), industry price-to-sales ratio, insider retention, and investment banker prestige ranking.

We then compare this valuation model with the valuation during the new economy period, 1997-2001. Given the dramatic collapse of NASDAQ and other stock markets in March 2000, some observers have argued that the market for new economy stocks, and especially IPOs, was significantly altered after March 2000. Therefore, we break down the period 1997-2001 into two subperiods, January 1997 to March 2000 and April 2000 to December 2001. We label these as the boom and crash periods, respectively. We also investigate valuation differences between technology and nontechnology companies, and Internet and non-internet companies.

We use the valuation model of Abel and Eberly (2005), which explicitly incorporates the possibility that firms may upgrade to or adopt a new technology, to motivate our choice of explanatory variables. In their model, the value of the firm comprises three components: 1) the replacement cost of the firm's physical capital, 2) the net present value of the firm's expected future cash flows from assets in place, and 3) the value of growth options associated with future technological upgrades. The key point in their model is how close the firm is to a technological upgrade. (5) The closer the firm is to a technological upgrade, the more of firm value will be reflected in the technological upgrade growth option and less will be reflected in existing physical capital or (positive) firm cash flows. Because the late 1990s were a period of rapid technological change, this model of firm valuation seems particularly well suited to capture the salient determinants of value.