In Depth: Shanghai’s High-Tech Board Tests Brokerages’ Market Mettle

As Chinese regulators speed toward the launch of the much-anticipated Nasdaq-style high-tech board, domestic brokerage firms are facing a number of pressing challenges as they come to grips with a new system of initial public offerings (IPOs), especially how to calculate a fair market value for a company and how to price its shares.

The new technology board, whose official English name is the “Sci-Tech Innovation Board,” will be a testbed for a fundamental change in the way companies float on the stock market by allowing the market to play the dominant role in the process. The board is also breaking new ground by allowing companies that aren’t profitable or that have no revenue to gain a listing, and by abolishing a cap on a key valuation metric for IPO companies — the price-earnings (PE) ratio, the ratio of a company’s share price to its earnings per share. The highest PE ratio currently allowed by the regulator for an IPO candidate is 23.

But brokerages, which sponsor IPOs, will still have to work within guidelines set by the regulators. They will have to provide an initial assessment of a company’s market value including the basis, method of calculation and conclusion of their valuation process, and then try to achieve that price by securing enough demand from investors, a process known as book building. If there’s a significant difference between the preliminary appraisal value and the final valuation resulting from book building, the company may have to scrap its listing. Failure to accurately measure the valuation of an IPO candidate could also affect the sponsor’s performance in the Shanghai Stock Exchange’s (SSE) internal assessment system.

These changes are causing big headaches for domestic brokerages. The problems are even greater when the listing candidate is unprofitable — money-losing companies are not allowed to list on the country’s existing bourses and if they have no earnings they can’t be valued using the PE ratio metric, one of the main criteria in deciding the price of shares in an IPO. Companies with no revenues are also problematic to value.

Lacking experience

“This pricing issue is really stressful for us,” a senior executive with a brokerage, who declined to be identified, told Caixin. “Brokers have no experience in pricing (under the new system) and if the final estimated market value of a company based on market demand turns out to be significantly different from our preliminary appraisal, our performance in the SSE’s assessment will be affected.”

Yi Huiman, the new chairman of the China Securities Regulatory Commission and a veteran banker, added his voice to the concerns during his debut press conference on Feb. 27. “One of the most different features of the high-tech board compared with other boards is the pricing and underwriting of shares,” he said. “It will test the core competitiveness of an investment bank. We are worried that some of the domestic brokerages might lack the proper experience, and it’s important for them to do full preparation to improve their capabilities.”

The final rules for the new board, released on March 1, do provide guidelines on how to price firms’ estimated market value when a company is unprofitable or has no revenue. The recommendation is to base the valuation on the latest round of private equity financing or the market value of counterparts listed on overseas stock markets.

But executives at some brokerages say the guidelines are vague and don’t take some important factors into account. They say a bubble has built up in the valuations of the types of mainland startups that the board wants to attract. That’s because cash-rich private equity firms have competed for deals, making such companies too expensive for institutional investors. In addition, the valuations of domestic high-tech companies are often much higher than those of firms listed in other countries, which could lead to mispricing if brokers have to use overseas valuations as a proxy.

“Pricing a pre-profit company is an art” not a science, one institutional investor told Caixin.

Brokerages are also concerned about the damage to the IPO candidate and their own standing if there is a significant discrepancy between the preliminary valuation they provide and the final valuation based on demand from institutional investors in the book building process. Under the new rules, companies are required to terminate their IPO applications if the final market value fails to meet the minimum level specified in the new listing requirements.

Revenue vs. profit

To tackle the pricing headache, a source at Wanjia Asset Management Co. Ltd. suggested brokerages use another metric to come up with a valuation for pre-profit firms — the price-to-sales (PS) ratio, which is based on revenue.

“Operating revenue is a direct reflection of a company’s business operations,” the source said. “In the early stages, revenue may not be enough to cover the costs of the business and investment, but as the business grows and revenue covers costs, profits will follow. Some industries, such as software and online services, have low marginal costs so once revenue exceeds costs, profits can rocket. So revenue can be used as a leading indicator of profitability.”

Other experts, including Wang Jiyue, a veteran IPO sponsor, suggest the problem should be overcome by using a variety of market-oriented approaches rather than a single pricing model. Wang said regulators should also be more tolerant of share prices falling below their IPO price on the new tech board and let market forces decide on a fair price.

“At the end of the day, it’s about making money,” Wang said. Once a company is listed, the market should be allowed to decide what price is fair, he said.

Contact reporter Leng Cheng (chengleng@caixin.com)