Study confirms relation between IPO ratings, P/E multiples

“Higher IPO-graded companies typically tend to operate in higher growth industries, have superior management strengths and follow good corporate governance practices,” says Chetan Majithia, Head, Crisil Equities.

He said such characteristics tend to command better valuations, as reflected in higher price-earning (PE) multiples.

According to Crisil, companies with a higher IPO (initial public offering) grade of 4/5 (indicating above average fundamentals relative to other listed securities) have enjoyed average PE multiples of 25.8, compared to companies with a lower IPO grade of 1/5 (indicating poor fundamentals) at a 14.8 average.

Companies with IPO grades of 2/5 and 3/5 were trading at PE multiples of 17.6 times and 20.9 times, respectively, said the study. There are no IPOs graded 5/5 (indicating strong fundamentals) listed on the exchanges.

Since the time IPO grading was made mandatory in May 2007, more than 100 companies have been graded by various rating agencies, of which 75 companies have been listed.

“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 gradings and PE multiples reflects the broad similarity in the assessment of fundamentals by rating agencies and informed investors, thereby pointing to the efficacy of the gradings,” Majithia said in a statement.

To assess the relation between an IPO grade and its PE multiple, companies with similar grades and their average PE multiple was considered for the study. To derive the PE multiple, the stock price as on December 31, 2009, and the trailing four quarters’ earnings per share (EPS) was taken for the analysis. The output mirrored results from a similar analysis by Crisil Equities in May 2009, reinforcing the relationship between higher grades and higher P/E ratios.

While assigning an IPO grade, industry prospects and scalability of the business, coupled with earnings potential, management and corporate governance practices of the company were taken into consideration.