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Whenever a major company prepares to go public, the main thing that tends to dominate the headlines is valuation. Whether it’s an industry leader like OpenAI or the latest startup preparing for an IPO, the conversation about how much the company is worth is always top of mind. However, one thing that isn’t necessarily always clear to everybody is where those numbers actually come from.

It might be tempting to imagine that investment bankers simply plug a few figures into a spreadsheet or an equation and receive a definitive answer. But the reality is that IPO valuations are part finance, part forecasting and part judgement; there’s no single formula that spits out an objectively “correct” price. Instead, bankers, investors and company executives use a range of methods to estimate what a business could be worth when it starts trading on the public market.

Why Does Valuation Matter?

An IPO, or Initial Public Offering, is the process through which a private company begins to sell shares to public investors for the first time. The valuation for the IPO is important because it helps determine how much those shares will cost.

If you set the valuation too high, investors may decide the stock isn’t worth buying; but if you set it too low, the company could leave billions on the table. Thus, the challenge is finding a price that accurately reflects the company’s prospects while still attracting enough demand from investors.

Unsurprisingly, that’s easier said than done, especially when many of today’s fastest-growing companies are still prioritising growth over profits.

Making Comparisons To Similar Companies

One of the most common valuation methods is known as comparable company analysis, often shortened to “comps”. Now, this isn’t a strategy unique to IPO valuations – professionals use comps to value plenty of assets, from real esate to retail – and the idea is simple. If you’re trying to value a company, it helps to look at how similar companies are already being valued by the market.

For example, if a software company is preparing for an IPO, analysts might compare it to other publicly traded software businesses with similar growth rates, revenues and business models. Then, they’ll look at metrics like revenue multiples, earnings multiples or enterprise value ratios to estimate a reasonable valuation range.

Of course, no two companies are exactly the same in terms of their value. For instance, a business growing at 50% a year will probably be valued differently from one growing at 5%, even if they operate in the same industry. And that’s why comparables provide guidance rather than a definitive answer.

Estimating Future Cash Flow

Another major valuation technique is known as discounted cash flow analysis, or DCF. Rather than focusing on what similar companies are worth today, DCF attempts to estimate how much cash a company could generate in the future and then calculate what those future earnings are worth in today’s money. The logic is pretty straightforward: a pound earned ten years from now is worth less than a pound earned today.

Analysts therefore create forecasts for future revenue, profits and cash generation, then apply a discount rate to account for risk and the time value of money.ÌýThe challenge, however, is that forecasts can be wrong.

Small changes to assumptions about growth rates, profitability or future market conditions can have a huge impact on the final valuation, and that’s one reason why IPO valuation is rarely based on a DCF model alone.

Market Demand Is An Essential Consideration

One common misconception is that valuation and pricing are the same thingÌý– they most certainly are not.ÌýA company may have an estimated valuation based on financial models, but the final IPO price is also influenced by investor demand. During the IPO process, underwriters meet with institutional investors, gauge interest and assess how much appetite exists for the shares.

If demand is particularly strong, the company may be able to price its shares towards the upper end of the expected range. But if enthusiasm is weaker, the price may need to come down.

So in other words, valuation is a financial exercise; pricing is also a market exercise.

ÌýWhy Do Some IPOs Seem Expensive?

If you’ve ever looked at a tech IPO and wondered how a company currently making a loss could still be worth billions, you’re certainly not the only one. But the reason for this isn’t quite as mysterious as one may think. Indeed, it’s because investors aren’t just paying for what a company is today; they’re paying for what they believe it could become in the future. They’re paying for potential.

This is particularly common in high-growth sectors like AI, software and biotechnology. Investors may be willing to accept high valuations if they believe future growth will eventually justify them. Of course, this comes with a significant amount of risk, because they’re definitely not always right. Indeed, history is full of companies that exceeded expectations after going public and others that struggled to live up to the hype.

How Is An IPO Value Actually Determined?

The simplest answer is that it isn’t determined by a single number or formula. Instead, investment banks typically combine multiple approaches, including comparisons with similar public companies, forecasts of future cash flows and real-world investor demand. And the result of those findings tends to produce a range rather than a precise figure.

Ultimately, an IPO valuation is less about finding a company’s exact worth and more about finding a price that investors are willing to pay. And as every public market eventually demonstrates, those two things are not always the same.