Equity exists whether in private or public markets because a company needs funding. Counterintuitively, equity held by a shareholder is also debt outstanding held by the company itself, but since the equity is issued not relative to the value of a currency (dollar, yen, whatever), the value of the equity when it is first issued must be made in relation to the value of the company itself. Hence every time a company raises funds it needs to evaluate how much it is worth.
But how much is any company worth? The volatility of the stock market and the rapid price changes of small cap companies tell us that valuing a company is actually very hard, and the smaller or more unknown a company is, the harder it is to value. This is actually a major tenet of the Efficient Market Hypothesis (EMH), which states that markets become less efficient when they have less participants and less exchange of information.
As a result, funding rounds for companies become more and more inefficient the more that the company needs to raise funding.
This is why both private equity and investment banking are specialized industries with very complicated and oftentimes opaque methodologies. But one of the primary tenets of valuing companies is that relative valuations matter. For instance, if I am Uber and I have just seen Lyft go IPO, I cannot accept a valuation below Lyft’s unless there is a very, very strong reason for that lower valuation (like a lawsuit or a much lower rate of growth). This is why companies in the same sector tend to have similar valuation multiples—they are more or less benchmarked against each other each time they raise funding.
This also means that a company’s ability to value itself is relative to the market it operates in and, paradoxically, its value can go down when its competitors are hurting. If the mobile game app world is seeing a massive downturn in valuations due to one game developer releasing a number of flops, another mobile game app company can see its ability to value itself highly go down even if it keeps releasing hit after hit.
This relative valuation is also why IPOs tend to have cycles: if one company has an IPO that goes badly, others in the same industry may hesitate to go IPO because the valuation they can attract has declined. The long-awaited IPO of Pinterest (PINS) is a fine example of this principle in practice; their rumored IPO in 2014 and 2015 were both stymied by the collapsing price of the stock of one of its competitors: Twitter (TWTR). When Twitter fully recovered in 2018, PINS finally began to prepare for its most recent IPO.
This is a bit of an oversimplification (Facebook’s declining dominance as a de facto monopoly in the sector is another aspect of the story), but the general principal applies. And this is important for underwriters and dealmakers, because they need to be highly attenuated to the atmosphere in the market to get the IPO price just right. And before that, underwriters need to be equally sensitive to demand in the private market to ensure the funding round will succeed and not overstep the valuation potential of future funding rounds.
As you can imagine, this can get very messy very quickly. Despite the simple elegance of the math behind an IRR calculation, real-world valuations involve a lot of psychological guesswork and sociological analysis of crowd behavior and general sentiment. Sensitivity to the feelings of market participants is a key asset of a successful banker alongside the algebraic competence required to formalize those feelings in numbers.
What is a budding financier to do? Clearly, understanding human psychology and behavior is essential. Behavioral economics has grown in popularity for good reason; understanding when and how models fall apart is crucial to create models that will fall apart with less ease. And the financiers who create the most robust models in the face of capricious human emotions will find their skills in high demand very quickly.