- When a company offers to sell its shares
to the public for the first time,
the event is called an IPO,
or an initial public offering.
Because there is no active buying or selling
before the shares are listed publicly,
an initial price must be set just to get things going.
This initial price is set by the listing company
and its financial advisers.
Well, let's take a look at an example
of a company that went public a little over 30 years ago.
Microsoft went public on March 13, 1986.
The company had been operating since 1975
as a privately-held company.
A number of employees had been given shares
as part of their compensation,
but there was no market in which to trade those shares.
In 1985,
the year before the IPO,
Microsoft had earnings per share of $1.10 per share.
At the time of Microsoft's IPO,
there were several other software companies
that were already publicly traded.
Those companies, on average,
were trading at a PE ratio or price-to-earnings ratio
of about 15.
In other words, the market values of those companies
were about 15 times as large
as those companies' most recent annual net income.
So what's a reasonable estimate of the initial value
of Microsoft's shares,
given that the company's most recent
earnings per share was $1.10?
That initial estimate, which founder Bill Gates
and his financial advisers used was $16.50 per share,
computed as $1.10 earnings per share
multiplied by the industry average PE ratio, 15.
Okay, that's an initial rough estimate,
but when investors buy the shares at that 16.50 price,
Bill Gates and his financial advisors
did what most companies do
as they're preparing to go public.
They conducted a road show.
They went around the world and gave presentations
about Microsoft to large investors,
mutual funds, pension funds, and so forth.
They told these large investors that the initial price
per share estimate was $16.50,
and asked them if they would be willing
to invest at that price.
Well, at that $16.50 price,
lots of people wanted to buy Microsoft shares.
Now who suffers if the initial share price is too low?
Well, the original shareholders,
such as founders Bill Gates and his partner, Paul Allen.
They're not fully compensated for their work
in creating the company.
So what is the danger if the initial price is too high?
Well, then nobody wants to buy these overpriced shares.
The IPO shares are said to be undersubscribed.
This results in bad publicity.
So, what happened?
Well given the positive feedback from the road show,
Bill Gates and his investment advisers decided
to set the initial share price at $21 a share,
a bit of an increase over the initial 16.50 number
computed using the PE ratio.
The Microsoft shares proved to be an instant success
in the market.
At the end of the first day of trading,
their share price was up to $27.75,
about a 30% increase in one day.
The IPO price is set using accounting data,
industry data, and the investor interest uncovered
during the road show.
Once the shares are trading in the market,
the interactions of buyers and sellers determine the price.
And what is the current price of those Microsoft shares
that sold for $21 in the IPO?
Well, those shares have been multiplied
in a process called stock splits,
so now, each original share is equal to 288 shares.
As of October 1, 2018,
the aggregate price of those shares is $33255.
From the $21 IPO price up to $33255, not bad.