Higher graded IPOs command higher P/E multiples: Crisil

An analysis of 117 listed initial public offerings (IPOs) carried out by  Crisil Equities’ has revealed that IPOs which have received higher grades from rating agencies continue to enjoy higher price-to-earnings (P/E) multiples. The companies covered, include those listed between May 1, 2007, when IPO grading was made compulsory and December 31, 2010.

So, companies with an IPO grade of 5/5 (indicating strong fundamentals) command an average P/E multiple of 18.39x compared to 10.13x for companies with an IPO grade of 1/5 (indicating poor fundamentals). Companies with IPO grades falling between these extremes (2/5, 3/5 and 4/5)  have been trading at average P/E multiples of 10.81x, 17.82x and 18.10x, respectively. This results of this new analysis are in line with those of earlier studies (May 2009, January 2010 and July 2010) carried out by Crisil Equities, as per a statement issued by the rating agency.

The methodology used involved dividing the closing stock price of the companies as on March 31, 2011 by the reported diluted earnings per share for the trailing four quarters (March 2010 to December 2010) to arrive at a P/E multiple for the company. The average P/E multiple were then arrived at for the companies in each grade.

During the period under consideration, 139 IPOs were graded and listed. Out of these 18 companies showed negative earnings per share or P/E multiples of more than 50x. These were excluded as they were considered outliers. In addition, four companies which did not publish their quarterly results were also excluded from the study.

Commenting on the study, Tarun Bhatia, director, capital markets, says, “Sustained positive correlation of P/E multiples with IPO grades reaffirms the importance of the fundamental assessment of a company for the investors at the time of investment in its IPO. The market price of a stock can be influenced by factors other than fundamentals, such as liquidity and market sentiments. Despite this, the positive correlation consistently observed between IPO grades and P/E multiples reflects the broad similarity in the assessment of fundamentals by rating agencies and informed investors, thereby pointing to the efficacy of our grading exercise.”

And Chetan Majithia, head,  Crisil Equities, added, “Companies with higher IPO grades command higher P/E multiples as they have better growth prospects given their strong business fundamentals supported by superior management strength and governance practices—  the critical determinants for long-term shareholders’ wealth creation.”

While assigning an IPO grade,  Crisil Equities takes into account industry prospects and scalability of the business along with earnings potential, management and corporate governance practices of the company. IPO grading focuses on the company’s fundamentals and is independent of the issue price.