Initial Public Offerings have become a common phenomenon on the Indian stock exchanges. Besides being a medium for companies to raise funds, IPOs are also an indirect indicator of the strength of the economy. With economic growth mellowing down in 2019, the activity in the primary market slowed down. Companies raised just Rs 12,362 crore through IPOs in 2019, as against Rs 30,959 crore last year.
The primary markets can give you interesting insights into the condition of the economy, which makes it important to understand even the minute details of an IPO. While the major terms like IPO size, price band and opening and closing dates are well-known, some terms can be confusing.
What is an IPO?
When a private company issues shares to raise funds from the public through the stock markets, it is known as an initial public offering. A public offering is generally conducted by a company to raise funds for expansion or to provide existing shareholders with an avenue to unlock some value of their stake. The dominant method of IPO is the book building method.
The book-building method discovers the issue price during the IPO process by assessing the demand for the IPO. In the book building method, the company announces a price band for the issue and investors place their bids for a specific number of shares at different price points. Depending on the bids for the number of shares at each price point the final issue price is determined. The subscriber data is updated daily in the book building method.
During an IPO through the book building method, the company declares a price band of shares, but along with the price band, face value is also announced. The lower end of the price band is known as the floor price and the upper end of the ceiling price. The final issue price is set above the floor price but equal to or below the ceiling price.
The floor price, ceiling price and the issue price are important terms, but why do companies announce face value of the shares. The face value, also known as the par value, is the nominal value of the shares. The face value is either Re 1, Rs 2, Rs 5 or even Rs 100. The issue price or the price band are the face value of the shares with an added premium that the company decides to ask from potential subscribers.
The issue price= face value + premium
The premium is not a randomly decided amount but depends on the performance metrics of the company like sales, profit and growth. There have been IPOs that have set the price band near the face value of the shares, which means the company sought minimal premium. The meaning of face value is clear, but what is the utility of the face value.
After listing, the stock price of a company changes according to the market conditions and the performance of the company. The share price is dependent on the market, but the face value is not, which is why companies use the face value to announce share splits. For instance, suppose the share price of company ABC has touched Rs 5000. Its face value is Rs 10. Paying Rs 5000 per share would be out of the question for many retail investors in India. To increase the liquidity of the shares, the company could split the shares into five shares. After the split, the face value will be Rs 2 and the shares price will come down to Rs 1,000.
Similarly, when companies announce a dividend, they use the face value rather than the share price. If a company with a face value of Rs 2 and share price of Rs 200 announces a dividend of 100% of the face value, it means a dividend of Rs 4 per share.
With a clear understanding of terms like face value and premium, you can make a more informed decision while investing. Many corporate actions announced by companies mention the face value. Getting caught up in technicalities, however, should not be a reason to delay investing in the capital markets.