The cut-off price in an Initial Public Offering (IPO) plays a pivotal role in determining the company's market capitalisation and valuation. This price, set by the company, establishes the initial value of its shares. Investors use this benchmark to decide whether to purchase shares during the IPO process.
In this article, we will delve into the importance of cutoff prices in IPOs, the types of IPO pricing, how to select the cut-off price while applying, and ways to enhance your chances of allotment.
What is cut-off price in IPO?
The "cut-off price" in an IPO is the price determined based on evaluation of the company's financials, market conditions, and demand for its shares. It is the price at which investors can place bids for shares during the IPO subscription period. The cut-off price aids in achieving a delicate balance between the company's valuation and the interest of potential investors.
Two Types of IPO Pricing
IPOs can be priced using two main methods: fixed price and book-building. Each method has its own implications for the cut-off price:
1. Fixed price IPO
In a fixed price IPO, the company offers its shares at a predetermined fixed price to the investors. This price is the same for all investors participating in the IPO. Investors who want to subscribe to the IPO need to apply at the fixed price set by the company. There is no variability in the price at which shares are allotted to different investors. This pricing method is relatively simpler and more straightforward.
2. Book Building IPO
In a book-building IPO, the company and its underwriters specify a price range within which investors can bid for shares. This range consists of a minimum and maximum price. Investors then place bids for the number of shares they want to subscribe to, along with the price they are willing to pay. The cut off price is the price at which shares are allotted to the investor. The final issue price is determined based on the demand generated at different price levels. This pricing method allows for greater investor participation and flexibility.
Both pricing methods have their own implications for investors and companies, and the cut-off price plays a key role in the book-building process by indicating the minimum price investors can bid for shares.
Factors affecting cut-off prices in IPOs
IPOs are one of the most crucial processes in the stock market. They allow companies to raise capital from the general public by offering them their shares for the first time. However, it is a common scenario that some companies offer their IPOs at a premium (higher than the cut-off price) while others open at a discount (lower than the cut-off price). Hence, it is crucial to consider the following factors before applying to IPOs:
1. Market conditions
Market conditions largely affect the cut-off prices in an IPO. Market conditions include the current market trend and investor sentiment. For example, if the economy is fearing a recession, it can lead to a sell-off in the market and result in a downtrend. In such a market, the cut-off price may decrease and can be set at the lower price band. On the other hand, if the economy is performing well and the investor sentiment is high, the demand can increase and the company can set the cut-off price at the higher price band.
2. Demand and supply
Investors can oversubscribe to an IPO, indicating that there are more bids than the available shares. During an oversubscription, the demand is high, and the cut-off price is likely to be set at the higher end of the price band. The demand, especially from institutional investors and High Net-worth Individuals (HNIs), is significant in pushing the cut-off price upward. However, if the IPO is undersubscribed, it indicates that the supply of shares is higher than the demand. In such a case, the cut-off price may be closer to the lower end of the price band, or the IPO may fail to proceed.
3. Company fundamentals
Investors decide whether to invest in an IPO or give it a miss based on their fundamental analysis of the company coming out with an IPO. For a company to be able to set its cut-off price at the higher end of the price band, its past financial performance, profitability, revenue growth, and margins must be positive. Furthermore, it must also have future growth potential, competitive edge, and capacity to sustain. Companies with a robust and innovative business model, large customer base, and unique selling propositions (USPs) tend to attract more investors, driving the cut-off price higher.
4. Industry trends
Investors analyse companies coming out with an IPO based on their valuation metrics and use tools such as the price-to-earnings (P/E) ratio. If the peers are trading at high valuations, it can justify a higher cut-off price for the IPO. Industry-specific factors, such as regulatory changes, technological advancements, or shifts in consumer behaviour, can also impact the cut-off price. For example, a financial institution may see a higher cutoff price if the RBI has lowered the key repo rates, leaving investors with higher disposable income.
5. Peer Comparison
Investors often compare the valuation and performance of a company to its peers in the market. A company with a higher valuation than its peers, without a strong justification, may deter investors and negatively impact the cut-off price. Conversely, an undervalued company relative to its peers may attract higher bids.
6 Speculative Interest
Speculative interest can significantly impact the cut-off price, particularly if the IPO is perceived to have significant short-term potential. This can be fueled by media hype, market rumors, or a recent trend of successful IPOs in the sector.
7. Promotional Strategies
The effectiveness of the company's and underwriters' promotional and marketing strategies can influence investor sentiment and the cut-off price. Strong communication of the company's strengths, growth prospects, and business model can boost investor confidence and lead to higher bids.
8. Economic Indicators
Broad economic factors like interest rates, inflation, and GDP growth rates can impact investor sentiment and, consequently, the IPO cut-off price. Lower interest rates, for instance, can stimulate investment in the stock market, including IPOs.
Importance of cut-off price in IPO
The cut-off price is a crucial factor in an Initial Public Offering (IPO). It plays a pivotal role in ensuring fair allocation, maximizing allotment chances, reflecting market sentiment, and determining the final issue price.
- Fair allocation: The cut-off price mechanism helps ensure fair allocation of shares among investors, especially in highly sought-after IPOs where demand may exceed supply.
- Maximizing allotment chances: By bidding at the cut-off price, investors increase their chances of being allotted shares. It signals flexibility to the company and underwriters, indicating a willingness to pay the highest price within the specified price band.
- Reflecting market sentiment: The cut-off price serves as a barometer of market sentiment towards the IPO. A high cut-off price indicates strong investor interest and confidence in the company's future prospects.
- Determining the final issue price: The cut-off price directly influences the final issue price of the IPO. If the IPO is well-received, the final issue price is often set at or around the cut-off price.
Why select the cut-off price?
1. Increased allocation probability
Selecting the cut-off price can significantly boost your chances of securing an allocation, especially in oversubscribed IPOs. By agreeing to pay the highest price, you demonstrate strong commitment as an investor.
2. Simplified bidding process
Choosing the cut-off price streamlines the decision-making process. Instead of deliberating over the optimal bid price within the given range, you simply opt for the maximum price, making the process efficient.
3. Flexibility
This approach offers flexibility as the final issue price may be lower than the cut-off price, particularly in cases of undersubscription.
Significance of cut-off price in IPO
The cut-off price plays a crucial role in the IPO process and has several implications:
1. Price discovery
The cut-off price is a key component of the price discovery mechanism, influencing the final issue price. By analysing the demand for shares at various price levels, the underwriters can determine a fair valuation for the company.
2. Fair allocation
The cut-off price ensures a fair allocation process. Investors who bid at or above the cut-off price have a higher probability of securing shares. Those who bid below may receive a partial or no allocation.
3. Investor guidance
The cut-off price provides a reference point for investors to calculate their minimum investment. It helps them determine the number of shares they can purchase based on their budget.
4. Price stability
The cut-off price acts as a price floor, helping to stabilise the stock price after listing. This can prevent excessive price volatility and speculative trading.
Selecting Cut-off Price while Applying
When applying for an IPO, investors have the option to either bid at the cut-off price or at a higher price within the price range. If the demand for shares exceeds supply, allotment is done on a lottery basis. However, bidding at a higher price increases the likelihood of getting allotted shares if the final price is above the cut-off.
Investors should consider their assessment of the company, market trends, and their own financial goals when deciding whether to bid at the cut-off price or above.
Example
Let's delve into a hypothetical example featuring an Indian company, ABC Ltd., planning to launch an IPO. The predetermined price band for shares is set between Rs. 150 to Rs. 170.
Retail Investor P bids for 200 shares at Rs. 160 per share.
Retail Investor Q bids for 100 shares at Rs. 155 per share.
Retail Investor R bids for 50 shares at Rs. 165 per share.
Retail Investor S bids for 300 shares at Rs. 150 per share.
In this example, the company's book-building process collects bids from both retail and institutional investors. The cut-off price is the price at which the maximum number of shares can be allocated to the investors. Let's assume the cutoff price is determined to be Rs. 160 per share.
Retail Investor P, who bid at Rs. 160, will secure 200 shares at the cut-off price.
Retail Investor Q, who bid at Rs. 155, will also be allotted 100 shares at Rs. 160.
Retail Investor R, bidding at Rs. 165, will receive 50 shares at the cut-off price.
Retail Investor S, bidding at Rs. 150, might not receive any shares if demand exceeds availability at the cut-off price.
The cut-off price ensures fairness in share allocation while aiming to align the company's valuation expectations with the market demand.
Calculation of cut-off price
The calculation of the cut-off price in an IPO is a process that balances market demand with the company's pricing intentions. In India, IPOs are typically issued through a book-building process. The cut-off price is determined by analysing all bids received during the bidding period.
Formula for calculating cut-off Price
The cut-off price in an IPO is essentially the highest price at which the IPO can be fully subscribed. It's determined by analyzing the demand for shares at different price levels within the price band.
Here's a simplified breakdown of how the cut-off price is calculated:
Parameter |
Description |
Total Demand |
The sum of shares bid for at each price level within the price band. |
Available Shares |
The total number of shares the company is offering in the IPO. |
Cut-Off Price |
The highest price at which the total demand equals or just exceeds the number of available shares. |
In simpler terms:
Cut-Off Price = Lowest price at which ∑(Demand at each price level) ≥ Total available shares
This means that the cut-off price is the lowest price at which the cumulative demand for shares equals or exceeds the total number of shares on offer.
Improving Chances of Getting Allotment
While there's no guaranteed method to secure an allocation in a highly oversubscribed IPO, these strategies can increase your chances:
- Multiple applications: Submitting applications through various channels, such as savings and demat accounts, or in the names of family members, can improve your allocation chances. However, it's crucial to adhere to SEBI regulations.
- Higher bid price: Bidding at a price higher than the cut-off price can increase your chances of allocation, especially if the final issue price is higher.
- Early application: Applying on the first day of the IPO period can give you an edge, as it demonstrates strong early interest.
Role of cut-off price in IPO
The cut-off price is a crucial factor in an Initial Public Offering (IPO), particularly in the Indian context. It plays a pivotal role in several aspects of the IPO process:
1. Gauging investor interest
The cut-off price represents the highest price within the price band at which the company's shares are issued. By bidding at the cut-off price, investors demonstrate strong interest in the IPO and their willingness to pay a premium.
2. Maximizing capital raised
A well-determined cut-off price helps the company maximize the capital raised through the IPO. By analyzing investor demand and setting an optimal cut-off price, the company can secure the best possible valuation.
3. Ensuring fair allocation
In oversubscribed IPOs, the cut-off price ensures fair allocation of shares among investors. Those who bid at or above the cut-off price have a higher chance of securing shares, regardless of their investor category.
4. Shaping market perception
A high cut-off price indicates strong investor demand and can positively impact the market's perception of the company. This can lead to a strong market debut and subsequent price appreciation.
5. Price discovery
The cut-off price mechanism aids in price discovery. It reflects the market's assessment of the company's value, helping to set a realistic price for the shares when they start trading.
Conclusion
In conclusion, the cut-off price in an IPO holds immense significance in determining the entry point for investors. It's a reflection of the company's valuation and investor sentiment. Aspiring IPO investors must understand the different pricing methods, evaluate market conditions, and consider their own financial objectives.
