14.1The Microsoft IPO
J: Who is the smartest person in the world?
K: You’re looking at him.
J: Very funny. Next guess?
K: I don’t know if he is THE smartest, but I have always thought that Bill Gates is pretty smart.
J: Agreed. So, let’s talk about the valuation process that Bill Gates used when his company, Microsoft, when public back in 1986.
K: Microsoft started business in 1975. The company was originally structured as a partnership between the two founders – Bill Gates (64%) and Paul Allen (36%). The company was incorporated in 1981.
J: As of early 1986, five of Microsoft’s competitors had recently gone public. These companies had price-earnings multiples ranging from a low of 10 to a high of 21, with an average of 15.
K: Bill Gates, who held the titles of chief executive officer and chairman of the board, had been approached by several investment banking firms urging him to take his company public.
J: Mr. Gates was drawing a salary of just $133,000 per year from the company; the investment bankers pointed out that if he were to go public and sell just a small fraction of his shareholdings, he could instantly become a multi-millionaire.
K: To get an initial estimate of the IPO price, Bill Gates and his investment advisors simply took the industry average P/E Ratio of 15 and multiplied it by Microsoft’s $1.10 earnings per share from the prior year. This yielded an estimated price of $16.50 per share.
J: We know that this is EXACTLY what Microsoft did to get an initial IPO price-per-share estimate. A Fortune reporter followed Bill Gates around during the IPO process and wrote an article about it after the IPO.
K: With this $16.50 per share estimated value, Bill Gates and his investment advisors conducted a “road show,” traveling around to various big cities and describing Microsoft and its plans, and giving large investors an opportunity to indicate their interest in buying Microsoft shares at this $16.50 price.
J: Bill Gates didn’t want the IPO price to be too low, because he would then be giving away some of the value of the company to the new shareholders coming in as part of the IPO.
K: But he also didn’t want the IPO price to be too high. No one would want the shares, and there would be bad publicity about Microsoft in the financial community.
J: Well, the road show revealed that there was lots of market interest in Microsoft shares at the preliminary price of $16.50. The investment advisors suggested raising the price to $24 for the IPO, but Bill Gates, a little nervous about the embarrassment of issuing the shares at $24 and having them immediately decline in value, decided that the IPO price would be $21.
K: Well, the IPO was a great success. The shares went public on March 13, 1986 at $21 per share. By the end of the first day of trading, the shares were up to $27.75, a 30% increase in one day. Microsoft got GREAT publicity from the IPO.
J: And if you had purchased one of those IPO shares for $21, you would now have 288 shares, because of stock splits, with a total value of over $13,000.
K: So, we agreed that Bill Gates is one of the smartest people in the world. And what tool did he use to get an initial value of his company?
J: A simple, market-based price multiple. In this module we will see how price multiples are used to value a variety of assets, from the share prices of high-tech companies to the total value of a Chinese telecommunications company to the house we grew up in in Grantsville, Utah.
K: By the way, whenever I see the increase of the value of Microsoft shares from the $21 IPO price to over $13,000 now, I could kick myself. I was a heavy user of the early Microsoft operating system, MS-DOS, in the early 1980s. I was aware of the IPO, but I missed the opportunity.
J: Well, that’s the way it goes.
K: But there is a silver lining to this cloud. You also were an MS-DOS user in the mid 1980s. You also knew about the IPO. And you were living just outside of Seattle at the time, basically in Microsoft’s back yard.
K: You were RIGHT THERE! How many of the IPO shares did you get?
J: None. Zero. Not a one.
K: Yes, I missed the opportunity, but so did you, and you were right there. I feel better.