An IPO can be exciting. A fast-growing business arrives on the stock market, the story sounds compelling, and investors finally get a chance to own a piece of it. But there is one question that matters just as much as the story itself: what price are investors being asked to pay?
That is where valuation comes in. Valuation is not about deciding whether a company is good or bad. It is about asking whether the share price already reflects the good news, the future growth, and the risks that still sit ahead.
A simple way to think about valuation is this. When you buy a share, you are buying a claim on a company’s future cash flows. The higher the valuation, the more future success is already baked into the price. That does not automatically make a highly valued company a bad investment, but it does leave less room for disappointment.
Price to Sales - paying for growth today
One of the simplest measures is price-to-sales. This compares a company’s market value with the revenue it generates. If a business is valued at £10bn and produces £1bn of annual sales, it trades on 10 times sales.
This ratio is often used for younger companies that are growing quickly but are not yet consistently profitable. It is particularly common in technology and platform businesses, where profits can be deliberately held back to invest in future growth.
But it comes with an important caveat. Sales are not profits. A company can grow revenue quickly and still lose money if it spends heavily to win customers or build out its platform. A high price-to-sales ratio, therefore, needs to be underpinned by a clear path to profitability.
Price to Earnings - the classic yardstick
Price to earnings, or P/E, is the most widely recognised valuation measure. It compares the share price with earnings per share. A P/E of 20 means that investors are paying £20 for every £1 of annual profit.
In isolation, a lower P/E can suggest better ‘value’, whereas a higher P/E points to greater expectations. But context matters. A high P/E may be justified if a company is expected to grow profits quickly for a sustained period, or if its earnings are reliable, transparent, and translate to strong cash flows. .
That is why investors often look at growth alongside valuation. Measures like the PEG ratio link P/E to expected earnings growth, helping to judge whether a valuation looks reasonable relative to the growth on offer.
EV/EBITDA - looking at the whole business
Another commonly used measure is EV/EBITDA. Enterprise value captures the value of the entire business, including debt and excluding cash, and EBITDA is a proxy for cash profit.
The combination allows investors to compare companies on a more consistent basis, especially when levels of borrowing differ.
However, it is not a complete picture. EBITDA excludes certain real costs, such as investment in assets, so it doesn’t always reflect the cash available to shareholders. It works best alongside other measures rather than in isolation.
What the textbooks say vs the real world
In traditional finance theory, valuation multiples are quick comparison tools. Lower multiples can indicate better ‘value’, and higher ones suggest stronger growth expectations.
In reality, it is more nuanced. Some companies have sustained high valuations for long periods because their competitive advantages are difficult to quantify. Strong brands, network effects, pricing power and scalable platforms can all support higher valuations than simple models might suggest.
These are factors that do not always fit neatly into a spreadsheet, but they can have a meaningful impact on long-term performance.
We prefer to look at multiples on a company-by-company basis first, then extend our thoughts to how they compare to peers second (if there are appropriate peers – sometimes there aren’t). We rarely think about multiples across sectors, as the underlying drivers are simply too varied.
Why IPO valuations can look stretched
This gap between theory and reality is often most visible at IPO. New listings frequently come to market with ambitious growth stories, limited public track records and valuations that can look demanding on traditional measures.
That is partly because IPOs often involve companies that are still in a relatively early stage of their public-market journey. They may already be well-known, fast-growing, and generating meaningful revenue. But profits may be thin, inconsistent or deliberately held back as management prioritises customer growth, product development or expansion into new markets.
There’s also been a shift in how companies come to market. More businesses are staying private for longer, supported by deeper pools of venture capital, private equity and late-stage growth funding. By the time they list, they can be much larger, but still in a growth period.
How investors should put it all together
For investors, the goal is not necessarily to avoid high valuations altogether. Some of the best-performing companies have looked expensive at first glance and still delivered strong returns.
Instead, valuation is best used as a sense check. Ask what the current price implies. Is the company already profitable, and if not, when might it be? Are margins likely to improve, or remain under pressure from competition?
It is also important to think about expectations. When valuations are high, a lot has to go right. Even solid results can disappoint if they fall short of optimistic forecasts.
Taking a balanced approach can help. Look at valuation alongside growth, profitability, competition and risk. And when it comes to IPOs, make sure the price leaves enough room for things not going perfectly.
This article isn’t personal advice. If you’re not sure an investment is right for you, seek advice. Investments and any income from them will rise and fall in value, so you could get back less than you invest. Ratios also shouldn’t be looked at on their own.
Investing in an individual company isn’t right for everyone because if that company fails, you could lose your whole investment. If you cannot afford this, then investing in a single company might not be right for you. You should make sure that you understand the companies you’re investing in and their specific risks. You should also make sure that any shares you own are part of a diversified portfolio.