Case 013Valuing listed securities: IPOs, DCF and REITsCore

A school chain is coming to IPO at a price band implying 62 times trailing earnings. 80% of the issue is an offer for sale by a private equity investor, and enrolments grew 9% last year. Should an equity fund apply, and what would it need to believe?

The situation

Gurukulika Education runs 80 K-12 schools across three states, at an average occupancy of 78% of seats. Enrolments grew 9% last year and fees rose about 7%. Trailing profit after tax is Rs 115 crore, and the top of the price band values the company at 62 times that, about Rs 7,130 crore.

The issue is Rs 2,000 crore. Rs 400 crore is a fresh issueNew shares created by the company. The money goes to the company and the existing owners are diluted., to fund 5 new schools at about Rs 50 crore each and repay Rs 150 crore of debt. The other Rs 1,600 crore is an offer for saleExisting shareholders selling their shares in the IPO. The money goes to the sellers, not the company. by a private equity investor that bought 30% of the company five years ago for Rs 540 crore. Your fund manager asks whether to apply.

Your task

Should the fund apply at the top of the band, and what would it need to believe for 62 times to work?

Quick check

Of the Rs 2,000 crore raised, how much reaches Gurukulika to fund growth?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Do not apply at the top of the band. Most of the issue is the seller's exit, and the price needs earnings growth of about 21.5% a year for ten years. The business grows about 16.6% today, and its existing schools can absorb only about 2.3 more years of 9% enrolment growth before it needs many more schools than this issue pays for. Revisit after listing at a lower multiple.

Step 1Who is selling, and who gets the money?

If a friend offers you a share in his restaurant, it matters whether he wants the money to open a second branch or to retire. In an IPO the first question is where the money goes: a fresh issue funds the company, while an offer for sale pays the people leaving. Here 80% is an offer for sale. The private equity investor paid Rs 540 crore for 30%; at the top of the band its stake is worth about Rs 2,139 crore, roughly 32% a year for five years. The Rs 1,600 crore it sells is about 3.0 times its whole cost. The seller chose the timing, after a good year, and set the price with the bankers.

Of Gurukulika's Rs 2,000 crore issue, only the Rs 400 crore fresh issue reaches the company, for 5 new schools and debt repayment, while Rs 1,600 crore goes to a private equity investor that paid Rs 540 crore for its stake five years ago.

Step 2What growth does 62 times assume?

Work it backwards. Suppose a mature school chain trades at 30 times earnings and the fund wants 13% a year, a higher bar than for a large company because this is a new listing with a short public record. To earn 13% a year and settle at 30 times in ten years, earnings must grow about 21.5% a year for the whole decade. Today revenue grows about 16.6%: 9% more students paying 7% higher fees. A decade at that pace supports about 41 times earnings, not 62. Margins could rise as schools fill, but schools also face regulatory limits on fee increases in many states, so that lever is weaker than it looks.

The relationship

(1+g)^{10} = \frac{62}{30} \times 1.13^{10} \;\Rightarrow\; g \approx 21.5\%

62	P/E at the top of the price band
30	assumed P/E once growth matures
1.13^10	price growth a 13% annual return needs over ten years
g	earnings growth a year the price assumes

What it says in wordsEarnings must grow fast enough to pay a 13% return and absorb the fall in the multiple from 62 to 30.

Step 3Can the existing schools deliver that growth?

This is where the use of proceeds matters. Occupancy is 78%; if a school can run at about 95%, existing schools have room for about 22% more students. At 9% enrolment growth that room is used up in about 2.3 years, after which growth needs new schools, and this issue funds only 5, about 6% more capacity. So the price needs a large building programme funded from future cash flow or more capital, and new schools take years to fill. A fund applying at 62 times is paying for that programme before it exists.

What 62 times needs	What the business shows today
Earnings growth of about 21.5% a year for ten years	Revenue growth of about 16.6%
Many new schools filled quickly	5 new schools funded, adding about 6% capacity
Rising margins	Fee increases subject to state rules
A seller with no information advantage	A seller exiting at about 4x its cost

Each condition the 62 times price needs is a stretch against what Gurukulika shows today, which is why a decade of current growth supports about 41 times rather than 62.

Step 4What is the decision?

A good business at a price set by a well-informed seller is a pass at the top of the band. Two things would change the view: a price nearer 41 to 40 times, which listed trading may offer once the initial demand fades and lock-ins on existing shareholders expire, or a credible plan, with funding, for many more schools. Note the limit of the reverse valuation: the exit multiple of 30 is an assumption, and education stocks have at times held higher multiples. Say that you are betting against that persisting, and size any later position for it.

Where candidates lose it

The usual loss is treating the IPO's total size as money for the business. Candidates talk about growth plans as though Rs 2,000 crore funds them, when Rs 1,600 crore leaves with the seller.

The second is applying because the business is good and IPOs often list higher. A first-day pop is not a fund's investment case; the price against the growth the business can actually fund is.

What the interviewer asks next

The offer for sale falls to 30% of the issue and the fresh issue funds 25 new schools. What changes?
How would you check whether the 9% enrolment growth came from existing schools or new ones?
What disclosures in the offer document would you read first?

Company names and figures are illustrative.