Jetblue Ipo Pricing Essay Example
Jetblue Ipo Pricing Essay Example

Jetblue Ipo Pricing Essay Example

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  • Published: September 18, 2017
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1. The introduction of an IPO involves a private company issuing shares to the public for the first time. These shares represent a fraction of the company's capital and entitle the shareholder to a share of profits in the form of dividends, as well as a portion of the company's value in the event of liquidation. Shareholders may also have voting rights on the board of directors and can influence corporate policy. (Draho, 2004).

The issuance of shares by a private company can result in funds being diverted towards multiple purposes such as repayment of debts, financing operating expenses, funding future company projects, or transferring to original investors. Conducting an IPO efficiently encourages entrepreneurship and economic growth, as it increases the availability of equity and lowers the cost of equity finance (Kleeburg, 2005). This report outlines a general IPO p

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rocess without delving into specifics for any particular country or region. It evaluates the pros and cons of opting for an IPO to raise capital and explores the commonly used pricing and allocation techniques. The final section illustrates the effectiveness of discussed pricing techniques by analyzing JetBlue's 2002 IPO as a case study.

The process of raising equity through an IPO involves five generic steps, as defined by Jenkinson and Ljungqvist (2001), which are exemplified in Figure 2.1. The following section briefly discusses each step, with a focus on the significance of the investment bank's role, as well as the pricing and allocation decision.

The act of 'going public' has two requirements: finding investors who are willing to purchase the shares, and complying with exchange regulatory conditions. While finding investors has historically not been difficult,

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modern global financial markets allow companies to choose the market that best suits their needs. The chosen market must have enough depth to allow the company to raise the necessary equity, and comply with stock exchange and regulatory regulations. The second stage of an IPO is preparing and lodging a prospectus with regulatory authorities.

When a company issues equity, a prospectus is created to outline the terms and provide information on financial and management performance. This document is crucial in ensuring potential investors have sufficient knowledge to make informed investment decisions according to the ASX (2008). To guarantee due diligence, investment banks are often involved in the preparation process. This involves an assessment to make sure that nothing in the prospectus is misleading by reviewing company contracts and tax returns, visiting facilities and offices, and interviewing industry personnel and company representatives according to Draho (2004).

The prospectus typically contains a fixed price or an initial price range set by the investment bank for the IPO. The initial price range is subject to adjustments as the IPO progresses. (Brau and Fawcett, 2006). Following the prospectus creation phase, the next step is to market the offering to potential investors.

Various forms of marketing are utilized by firms and investment banks to engage institutional investors. These methods often include a road show featuring presentations to targeted audiences. In cases where the price has been set (such as with fixed price offerings), the primary objective of this stage is to encourage investor bids.

The purpose of an indicative price range is to receive expressions of interest and initiate book building, which involves collecting non-legally binding offers in terms of price and

quantity. These offers are then used to develop a demand curve that enables a more accurate price range for subscription. The investment bank plays a crucial role in determining the marketing technique as the underwriter. The underwriting can either be a firm commitment, where the bank agrees to purchase all un-subscribed securities, or on a best efforts basis, where the bank will utilize its expertise to sell the securities to the best of their abilities.

When a fixed price is established, it is common for heavy over or under subscription to occur. In such cases, allocation methods like pro rata allocation, retail investor bias allocation or random allocation are applied based on the market regulators' policies (Jenkinson and Ljungqvist, 2001). Book building determines that in case of oversubscription, the allocation is usually based on a common strike price or pricing starting from the highest bid downward until the demand is met (Draho, 2004).

5. Following the completion of the IPO, the shares are typically traded within a few days after the final pricing and allocation decisions are made. In certain countries, the investment bank may participate in a price stabilization process aimed at safeguarding against downward price pressure upon commencement of trading. This process often involves the allocation of an over-allotment option, which typically accounts for 15% of the total shares issued and is sold during the marketing process (Geddes, 2003).

Table 3 outlines the pros and cons of choosing the IPO path for equity acquisition. Although there are significant advantages to this approach, it is important to also weigh the potential drawbacks.

Fishman (1993) presents a list of the main pros and cons.The advantages of going

public include partners obtaining true value of their shares, removing personal liability from creditors, improving overall financial condition, accessing more credit, reducing interest costs, increasing initial investors' financial wealth, providing free publicity, and creating a better corporate image. However, there are also disadvantages such as unpredictable market conditions resulting in loss of time and money, dissolution of partners' ownership leading to becoming mere employees, continued dealing with shareholders and the press being a time-consuming process, managers overlooking long-term strategic objectives due to shareholder pressure for profits and stock price, nation-wide presentations having to be made about the company's performance to interested parties, close scrutiny from the public due to continued success, and large amounts of fees and expenses associated with being a public company on a continual basis.Table 3 presents the pros and cons of undergoing an IPO process, where one advantage is gaining public reputation through a stock exchange listing.

IPO Valuation Techniques encompass determining the value of a company, which is crucial in both fixed price and book building offers. Investment banks use different methods to determine the initial IPO price, such as Discounting Methods that are based on a firm's intrinsic value (future cash flows), or the Comparable Multiples Method that values similar publicly traded companies (Geddes, 2003).

The Discounting Methods entail deriving the price of a share by discounting future cash flows accruing to shareholders. These techniques, such as Discounted Free Cash Flows (DCF) and Residual Income Model (RIM), are widely used in various industries. However, the practical application of these methods is limited as the forecasting of revenue and expenses entails risk (Draho, 2004).

Discounted Free Cash Flows refer to cash

flows generated from operations after factoring in investments in working capital and capital expenditures. Non-cash items such as depreciation, which cannot be used to pay shareholders, are excluded in the calculation of free cash flows while accounting earnings include them. To provide a more precise valuation of the company in terms of shareholder dividends, cash flows are discounted using a rate that factors in the level of risk. For a 100% equity company, the rate is derived from the Capital Asset Pricing Model (CAPM) while for a firm's debt and equity, the Weighted Average Cost of Capital is computed (Geddes, 2003).

The DCF model and the RIM model are both financial valuation methods that use a risk adjusted discount rate. The DCF model involves converting accounting earnings to cash flows, which may be deemed unsuitable due to the potential manipulation of accounting methods and the lack of consideration for the time value of money. On the other hand, the RIM model calculates the difference between expected earnings and realised earnings, where expected earnings is determined by multiplying the cost of equity with the beginning period equity book value (Draho, 2004).

Investment banks commonly use the Comparable Multiples method to value IPOs. This method involves comparing ratios of companies in similar businesses with similar risk, profitability, and growth prospects (Geddes, 2003). Various ratios can be used, including Price/Earnings multiples, Price/EBIT, Market value/Book value, and Price/sales. Choosing an appropriate comparison company is crucial for the success of this method.

One approach utilized by professionals involves choosing a maximum of 10 companies operating within the same industry and utilizing the group's median multiple to evaluate the issuer. The second,

more prevalent method is selecting 3-4 companies serving as direct competitors within the specific industry as the issuer. The third technique applies multiples of firms that have recently gone public, assuming all issuers have common valuation multiples (Jenkinson and Ljungqvist, 2001). Comparable multiples are a common method for valuing an IPO due to its simplicity and accuracy (Richardson and Tinaikar, 2004). Multiples negate the need for estimating the cost of capital and relying on projected earnings or valuation models. The use of multiples is supported by the idea that applicable ratios represent the market's estimate of risk and growth (Zarowin, 1990).

5. The pricing table for JetBlue (Table 5) displays the outcome of applying the techniques explored in the preceding section to calculate the share price for the 2002 JetBlue IPO. For full computations, refer to Appendices 1 and 2. The IPO's initial subscription price was established by the investment bank, Morgan Stanley, at $22-$24. However, it was amended to $25-$26 during the book building process. The share price was determined using two methods: Discounted Cash Flow Free Cash Flows ($94.00) and Industry Averages Price / Earnings Multiples ($40).

Market value/book value is $115.22 and price/EBIT is $33.13, with a leading EBIT multiple of $38.92. Competitor averages show a price/earnings multiple of $97.06 and market value/book value of $274.54, with a price/EBIT of $88.

Table 5.1 displays the share prices for the JetBlue IPO using various techniques, including a Leading EBIT Multiple of $33 and $65, a recent IPO's Leading EBIT Multiple of $40.37. It is important to note that the JetBlue opening share price at the end of the first day of trading

was $50.

It was shown that the IPO was significantly undervalued, with the price reaching its height in September 2003, slightly above $90.00. Currently, JetBlue's trading price stands at around $17.00.

The current price of the shares is $21, taking into account the adjustments made for three 3:2 share splits and dividends distributed. This represents a significant decrease compared to their initial trading in April 2002. It is unclear whether this is due to changing market conditions or suboptimal pricing strategies during the IPO. Appendix 3 contains historical monthly stock price data. Table 5.1 showcases the various prices that can be attained using different pricing techniques.

The technique of free cash flows analyzed Southwest Airlines data along with assumptions for the airline industry and cash flows given by JetBlue management (refer to Appendix 1). This resulted in a high value, which was influenced by strong investor demand that drove the share price over $90.00. When compared to multiple techniques, the industry average and recent IPO methods aligned with the first day closing price. However, the competitor average method produced similar results to the discounted cash flow technique. To account for any discrepancies in the data used for Southwest Airlines and JetBlue's conditions, a sensitivity analysis was conducted (refer to table 5).

The examination focused on four variables: the horizontal growth rate, the beta (which indicates company returns compared to market returns), credit rating, and debt-to-equity ratio. The predicted growth rates for shares priced at $94.00 were conservative at 3%, while the optimistic outlook predicted 5% growth and a share price of $133.44.

The anticipated value for 18 Beta is: Optimistic1. 1$149. 74, Forecasted1. 3$94. 00, and Conservative1. 5$52.

Projected credit

rating spread for 78: Ba (3.00%) with a forecasted value of $94.00 and OptimisticBaa (1.50%) with a forecasted value of $96.00.

The anticipated debt-to-equity ratio for ConservativeB is predicted to be 5.0%, with a projected value of $90.90. However, in an optimistic scenario, the ratio could increase to 5.0% and have a value of $94.00. The information is presented within HTML p tags.

Table 5 shows that Conservative investments yield a 2.5% return with a value of $86.96, while there is no return on the $108.03 investment.

The sensitivity analysis of share price reveals that fluctuations in the growth rate, beta, and credit spread lead to significant changes in the calculated share price. However, the impact of credit rating on the final value is minimal. This highlights the need for caution when relying on the discounted cash flow method, which relies on forecasting data.

In summary, the IPO process involves deciding which market to use for fundraising, preparing a prospectus to meet regulatory conditions, marketing to institutional investors and determining pricing and allocation based on subscription type. Pricing shares is a key challenge for both issuers and potential investors.

In pricing decisions, two main techniques are discounted cash flows and comparable multiples, which can result in significant value variations. The accuracy and reliability of forecasted and historical data are crucial to ensure precise pricing, particularly when considering the disadvantages of an IPO. It is important to prioritize accurate pricing to maintain investor engagement. While this case study does not allow for conclusions on the accuracy of techniques, it does showcase the complexities of pricing decisions.

Reference List: Australian Securities Exchange.

(2008, February 29). ASX Listing. Retrieved

on April 23, 2008 from http://www.asx.

Visit com.au/professionals/listing/index.htm to access Brau and Fawcett's (2006) examination of both the theory and practice behind initial public offerings.

The book "The IPO Decision: Why and How Companies Go Public" by J. Draho (2004) and an article in The Journal of Finance (Vol. 61, No. 1, pp. 399-436) provide insights into the reasons and processes behind companies going public.

In their 2003 book "Capital Markets: Institutions and Instruments" (2nd edition), Fabozzi and Modigliani discuss various aspects of the capital markets.

The Secured Lender has a publication by Fishman, L. (1993) titled "Going public: The pro's and cons" which references New Jersey's Prentice Hall.

Geddes (2003) discussed the topic of IPO's and equity offerings in volume 49 issue 4, pages 58-60.

The publication titled "Oxford, UK. Butterworth-Heinemann. Jenkinson, T. & Ljungqvist, A. (2001)" is available in HTML format.

"Initial Public Offering" by Kleeburg (2005) and "Going Public: The Theory and Evidence on How Companies Raise Equity Finance" (2nd ed.) published by Oxford University Press Inc. in the United States both pertain to the process of companies raising equity finance.

The citation includes Ohio, Thomson, Richardson, Gordon D, and Surjit Tinaikar's 2004 article "Accounting based valuation models: what have we learned?" published in Accounting and Finance journal. Additionally, Paul Zarowin's 1990 article is referenced.

The determining factors of earnings-to-price ratios are reviewed in the Journal of Accounting, Auditing ; Finance, Volume 5, Issue 3, pages 455-457.

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