20 June 2022
Empirical studies have shown that a majority of initial public offerings (IPOs) are underpriced by 18 to 47%. In this simplified guide, we take a look at IPO underpricing to explain the science behind it and how it affects all stakeholders in the stock market. Read this if you are trying to understand IPO underpricing in general and how it affects you as an investor.
An IPO stock is considered to be underpriced if its listing price is determined to be below market value either at the end of its first trading day or through other valuation methods. In most cases, the real value of new stock in the market is hidden from the public. The short-term performance of an IPO usually gives a clear indication of whether it was underpriced, overpriced, or fairly priced.
There are two types of IPO underpricing namely:
Let’s take a look at the two types of IPO underpricing in detail:
Deliberate IPO underpricing refers to the practice of investment banks or issuers underquoting the listing price when going public. Companies typically want to attract interest in their IPO because more interest means better market performance from day one. Ironically, the main aim of an initial public offering is to raise capital.
IPO managers do this with the knowledge that the low listing price is not likely to affect the company in the long term. It’s usually a gamble between attracting demand for the IPO or underperforming when the lower listing price does not attract desired demand. Most IPO managers are willing to take the risk of underpricing over overpricing because of the many other factors associated with going public.
The risk of having little or no interest in an IPO in the first few hours or days is too much for most companies to think so an attractive listing price must be set through underpricing. However, generating IPO demand isn’t the only reason behind IPO underpricing. IPO issuers or the investment banks managing new issues have many other reasons to underprice the stock price.
Take 2021 which was one of the most active years as far as companies going public according to statistics. At least 951 companies went public through an initial public offering with nearly all of them underpricing their IPO.
Though considered an anomaly, deliberate IPO underpricing is a very common practice, especially in the big exchanges like the New York Stock Exchange with many studies proving this. As an example, a 2019 empirical study of IPOs in the CSE showed that IPOs in the decade-long period under study were underpriced. Similar studies sampling IPOs from North American and European markets point to the same. You can most of these studies in the Journal of Financial Economics for reference.
Take 2021 which was one of the most active years as far as companies going public according to statistics. At least 951 companies went public through an initial public offering with nearly all of them underpricing their IPO.
As the name suggests, accidental IPO underpricing is when the listing price for a new issue turns out to be below the market value at the close of the trading day. Accidental IPO underpricing is fairly common in competitive industries as no company wants to see its stock price tumble on the first day of trading. A good example of an accidentally underpriced IPO was Twitter’s IPO back in 2013.
Even with advancements in valuation techniques and tools, IPO pricing is not an exact science and mistakes can be made. Often, investment banks behind valuation analyze large amounts of data as well as non-scientific methods to determine the ideal listing price for an IPO. There is always a likelihood that their models could be wrong as markets have and will always be unpredictable.
Sometimes, events between the time an issue price is determined and when it is announced play a role. For instance, a company in the oil sector can accidentally underprice its IPO if unpredictable events such as a competitor going under affects demand in the markets just before the issue. Underestimating IPO demand in the markets is one of the leading causes of accidental IPO underpricing.
Retail investors, as well as institutional investors, are usually quite attracted to IPO stocks that appear underpriced. It is the job of investment analysts to shop around for attractive IPO stocks that are underpriced. However, as an investor worth their salt would tell you, the listing price is just one among the many metrics used to measure the attractiveness or lack thereof of an IPO.
There are several reasons why IPO stocks are more likely to be offered at a lower price than they should be. The obvious one is the fact the pricing of initial public offerings is not an exact science; if it was, then there wouldn’t be a need to trade in stocks at all because every investor would win or lose.
Here are some of the technical and non-technical reasons why IPOs can be underpriced:
Sometimes initial public offerings are underpriced because of market uncertainty at the time of listing. A good example again is the Twitter IPO. At the time of going public, there was a lot of doubt about how the markets would receive another social media company’s IPO after the slow performance of Facebook’s overpriced IP. Underpricing the IPO cushioned Twitter’s IPO from market apprehension at the time meaning Twitter’s stock could only go up and they could hit their capital raising targets.
The whole point behind underpricing an IPO because of market uncertainty is to ensure that there is a cushion against first-day or short-term underperformance which is undesirable to the sponsor. It means the investment banker can sell the allocation of publicly traded shares quickly. Ideally, the underwriting company and the issuer would want to sell all the shares available to hit their target. It’s more important for the IPO underwriter because underperformance means their money is left in the deal for longer than anticipated.
Another common reason why IPOs shares may be offered at a lower price than the market price has to do with what is referred to as the “winner’s curse”. The winner curse in the context of issuance of IPO shares refers to where the listing price is deliberately lowered to encourage investor participation. If every IPO was fairly priced or overpriced, it would shrink the investor pool because only a small pool of sophisticated investors will be better equipped to make a profit from the IPO.
In most cases, the underwriting firms in a market are involved in most of the IPOs floated over a period of time. It’s therefore, in their interest to maintain market interest, especially from the retail investor to hit capital raising targets for their clients. These firms will always choose IPO underpricing where it is applicable to maintain this interest and cater to the winner’s curse.
Information asymmetry in the context of IPO pricing is the idea that the people behind the issuance of the IPO have privileged information meaning they can set a favorable listing price. At the same time, the fact that private companies are usually a black box means most investors tend to bid low. With the limited information they have about the company it’s unlikely that investors would warm up to a fair price IPO listing from day one.
In a typical IPO, the issuing company will provide financial data to the underwriter which they will then use to create a valuation. Now, in some cases, the issuing company may provide the underwriter with overinflated figures to get a good valuation and more capital from the IPO. Such a scenario would lead to an IPO underwriter inadvertently breaking the law by overvaluing it.
To protect themselves from lawsuits associated with blatant listing price overpricing, most underwriting companies are more inclined towards underpricing an IPO. In case the valuation was inflated because of being fed the wrong financial data, the underwriter will be. On the contrary, the share price of an underpriced company will always rise when it goes public and publishes its financials for all investors.
IPO issuers also tend to underprice an IPO to take advantage of the inherent bandwagon effect in the market. The bandwagon effect refers to the tendency of investors to rally behind an asset that they feel is cheap or underpriced. It has the same effect when people rush for newly listed products in a store that seems to be priced below their market value.
The bandwagon effect is very powerful in IPO trading as a large percentage of early investors are uninformed and always likely to jump on a trend if they can see an opportunity to make quick gains. Most initial public offerings are usually heavily marketed and hyped so it makes sense to milk the immediate exuberance using an attractive listing price.
In an initial public offering, there are both informed and uninformed investors. Informed investors are those that are likely to know the issuer’s true value while uninformed investors are those that do not have much information but hope that the listing price represents the fair value of the company. The insider-outsider theory in IPO investing capitalizes on this information asymmetry to ensure everyone has a fair chance of winning only when an IPO is underpriced.
Using the insider-outsider theory, an informed investor will be encouraged to buy into the IPO because they are aware of its true market value. On the other hand, outsiders or uninformed investors also ride on the attractive listing price hoping that it represents the fair price and with the hope of making gains as demand increases. In such a case, it is believed that both types of investors will win should their assessments hold which is guaranteed if an IPO is underpriced.
Another reason why IPOs are usually underpriced is to induce market feedback to drive the market value up. By deliberately underpricing the IPO, an issuer will cause investors in the market to compete against each other to buy into the IPO thus creating demand. Ultimately, inducing market feedback for an IPO means the issuer can raise the capital they need or even surpass it.
Initial Public Offering (IPO) underpricing is influenced by a complex interplay of various factors. Understanding these factors is crucial for both investors and companies seeking to go public. Here are some key elements that can affect the degree of underpricing in an IPO:
Different industries have their own dynamics. For instance, technology companies might experience higher levels of underpricing due to their growth potential and investor enthusiasm, while more stable industries like utilities may see lower underpricing.
The broader market environment plays a significant role. During bull markets and periods of high investor confidence, underpricing tends to be more pronounced as demand for IPO shares increases. Conversely, during market downturns, underpricing may be less prevalent.
Each company going public is unique. Factors such as the company’s financial health, growth prospects, brand reputation, and competitive positioning can influence underpricing. Companies with strong fundamentals and a compelling growth story may experience higher underpricing.
Regulatory requirements and legal constraints can impact IPO pricing. Securities regulations, disclosure rules, and accounting standards can affect how companies price their shares and communicate with investors.
These factors do not act in isolation but often interact with one another. For example, a technology company going public during a bullish market with a strong growth story may experience significant underpricing. Conversely, a company in a mature industry going public during a market downturn may see less underpricing.
Companies and investors should carefully consider these factors when participating in or managing an IPO. Tailoring strategies and expectations based on specific circumstances can help mitigate the risks and maximize the benefits associated with IPO underpricing.
IPO underpricing, where newly listed shares open at significantly higher prices than their initial offering, carries several key implications. For issuing firms, underpricing can translate into increased capital raised due to heightened investor demand, while also enhancing visibility and prestige. This practice can establish a committed shareholder base and instill investor confidence, setting a positive tone for the company’s market journey.
However, it’s worth noting that underpricing can also result from behavioral biases and herding behavior, highlighting the psychological dimensions of market dynamics. While it might seem counterintuitive, underpricing can efficiently allocate resources and potentially facilitate easier access to capital markets in the future. Nonetheless, both issuers and investors must navigate the complex landscape of IPO underpricing, considering its effects on long-term performance, regulatory aspects, and overall market behavior.
Nearly everyone involved in the IPO market is likely to benefit if the first day of trading does prove that it was underpriced. However, each of them will benefit in different ways based on their interest and role in the IPO market. The following is a breakdown of the entities that benefit from an underpriced IPO:
By far the biggest beneficiaries of an underpriced IP are the underwriters or investment banks. Underwriters take sizable compensation from the gains made on the stock price after an IPO because they take the entire risk of the IPO. Also, there are other fees and commissions involved throughout the IPO process which will are usually paid out to the underwriter. Underwriters or IPO firms who manage successful IPOs also attract more business.
The company whose shares are being sold to the public through an IPO also benefits if the listing stock price is low and it goes up even exceeding the fair price. The IPO issuer will be able to not only raise the capital it needs to grow but also raise its market valuation and reputation. An attractive market valuation means the IPO issuer can access more capital through other sources such as loans.
A portion of a company’s stocks will be retained to be divided among the insiders such as employees, preferred investors, and founders. This group of investors is guaranteed to benefit from an underpriced IPO if it performs as expected. With high demand for the IPO shares, the group of investors already holding the same shares at market value will see their value rise when the IPO is completed.
While every investor is likely to benefit from an underpriced IPO, it is the big institutional investors that take the lion’s share of the gains. Institutional investors, also known as sophisticated investors, usually have an edge over retail investors because they have better corporate finance tools and resources. They will often be the first to identify an underpriced first issue in the IPO price and cash in.
Ideally, all retail investors who are lucky enough to get in at the right time and buy an underpriced IPO stock price will benefit. A review of financial studies (journal of financial economics) of underpriced IPOs validates the point that a good percentage of underpriced IPOs benefit early investors equally. Of course, sometimes, underpricing also leads to losses if first-day gains do not hold in the long term.
The primary IPO underpricing theory suggests that IPO issuers and other stakeholders are justified to underprice because of the burden of liability imposed on them by the regulators. It is argued that underpricing ensures that sponsors of an IPO are cushioned from risks associated with aftermarket events. They don’t have to compensate investors if the stock price is deemed to have been lower than market value in the long run.
IPO underpricing is taken as an indirect cost by the issuer while bookbuilding. By underpricing, the issuer and by extension the underwriter are leaving money on the table for early investors. It is therefore taken as an indirect cost because these early investors will buy equity in the company below fair value. However, the indirect cost is recovered as demand for the stock rises due to attractive pricing.
There are numerous techniques and formulas used to calculate underpriced IPOS. However, the basic formula according to underpricing theory subtracts the offer price from the listing price and then divides it all by the offer price.
IPO Underpricing = (Listing price- Offer Price)/Offer price.
IPO underpricing usually has a short-lived negative effect on existing shareholders’ equity value. However, these shareholders will be among the top gainers when demand pushes the stock price up after the first day of trading.
IPO underpricing is a complex phenomenon with implications for both investors and companies. It’s crucial to understand the factors behind it and consider the risks and benefits carefully. Companies should manage underpricing strategically, while investors should approach IPOs with caution and a long-term perspective. In a constantly changing financial environment, staying informed and adaptable is key to success.
