IPO Underpricing – Who Benefits From Underpriced Stocks?

IPO underpricing is the increase in stock price from the initial offering price to the first-day closing price. There are many theories related to underpricing. Some state that underpriced IPOs leave money on the table for corporations. Others point to the fact that underpricing is inevitable.

Underpricing increases investor demand, which leads to a successful initial public offering. If the stock prices drop below issuance price soon after launch, then this exposes issuers to litigation. However, this also points to the fact that underpricing results in IPO firms leaving money on the table.

ipo underpricing explained

Who benefits from IPO underpricing?

It is important for underwriters and issuers to make IPO issuance successful. If the IPO offering price is too high relative to the fundamental value, investors will not invest. If the IPO price is too low compared to the fundamentals, then the issuer leaves money on the table.

Despite that, IPOs typically tend to be underpriced, and on average, everyone wins. Issuers win because they raised money to help expand their company. Investors also win if they invest in the right company. That’s why due-diligence is important.

It’s expected that the issuance price would be lower than the fundamental price. The reason being the issuer has been private for a while, and hence investors don’t have a clear picture of the fundamentals of the company. Compared to a public company, private companies have limited information in the public domain. This creates uncertainty and risks for investors. No wonder investors will expect a discount to take on that extra risk.

The upshot is that IPO is designed so that all the participants win. Underwriters get business, issuers get money, and investors get good businesses to invest money in. However, there are exceptions to this, when IPO fraud happens, or IPO issuance price is kept too high. In those scenarios, investors lose money. It’s a reflection of the fact that the SEC, underwriters, and institutional investors have not done their job.

In the early 2000s, Chinese firms used reverse merger to get themselves listed in the United States market. It is expected that small US investors lost over $100 billion dollars as most of the Chinese companies were fraudulent. To understand this issue in more detail, you may watch a documentary film titled The China Hustle.

Theories of Initial Underpricing

Information asymmetry theory

This theory says that investors are not informed about a firm going public. These firms are new to the public, and hence investors don’t have a history to back themselves. This creates an additional risk for the investors, and hence the investors are compensated for that risk.

Legal liability

If the issuance price is higher than the fundamental value, which gets revealed after a firm goes public, it will attract lawsuits. Facebook Inc. and Chief Executive Mark Zuckerberg had reached a $35 million settlement of class-action litigation post IPO. The firm was accused of hiding worries about the social media company’s growth before its May 2012 initial public offering.

Price stabilization

Issuers want to stabilize price post IPO as soon as possible. The more volatility there will be in the market, the more it will discourage the investors from participating. To stabilize prices, issuers use a legal mechanism called the greenshoe option.

A greenshoe is a clause contained in the underwriting agreement of an IPO that allows underwriters to buy up to an additional 15% of company shares at the offering price. An investment bank typically serves as an underwriter, whose job is to extract information from institutional investors and guide the issuer through the IPO process. Their role has expanded to ensure that the price discovery process is not volatile.

IPO underpricing FAQ

How to Calculate Underpricing Percentage?

If company AMC offers its shares in IPO at $100, and at the end of the first trading day, the stock closes at $150. In this case, underpricing will be [($150 – $100)/$100]*100 or 50%.

Is underpricing good or bad?

Underpriced IPO means that the firm and pre-IPO shareholders are shortchanged. Research shows that pre-liberalization, the underpricing, was more than 100 percent. The underpricing reduced post-liberalization to 80 percent. This implies that firms are losing out on a lot of money in IPOs on account of this imperfect price discovery.

Google adopted a Dutch auction path for better price discovery, thereby leaving less money on the table. But few firms are willing to go that path.

The investors who participate in the price discovery process, they obviously expect a lot of money left on the table. They can profit first by buying the shares at a lower price in IPO and then selling them at a higher price.

The underwriters frequently underprice the IPOs to help the big investors in this fashion. Research shows that underpricing has been more severe in a less mature market such as India. This is because of the level of information asymmetry that lies in those markets about public firms.

The United States has a robust legal system, ensuring a neutral and fast resolution of investor complaints. A swift and unbiased complaint resolution process is not found in many countries. This discourages a lot of investors to take part in the price discovery process. Hence, you can find that stocks listed on the Indian stock market are, on average, experience more underpricing.

Regulators such as SEC play a major role in the underpricing. If the regulators are reliable, it provides more comfort to the investors, leading to a reduced underpricing. For instance, in India, after the formation of SEBI (Securities and Exchange Commission of India) in the early 1990s, the level of underpricing was reduced massively.

Hence, it is easy to understand that IPOs are hot amongst new and old investors that are willing to sell the stock in a concise time frame. But what about long term investors and the firm itself? Aren’t these firms also losing money as well as control by way of underpriced IPO? What about the underwriters?

There has been enough research to show that underpricing is not necessarily bad for the stakeholders. The managers and long-term owners of the firm don’t only look at the shares they sell at IPO, but also the shares that they retain. IPO itself gives a quantum jump to the wealth of pre-IPO shareholders and creates a market for future issuance. Hence, the firm and shareholders need to ensure that many investors participate in the price discovery process.

Underpricing serves two fundamental purposes. Big institutional investors hold most of the shares post-IPO. Underpricing is the cost that issuers pay to extract the information from underwriters and institutional investors through the book-building process. This is the information extraction theory of underpricing. Benveniste and Spindt suggested it. Also, underpricing is done to attract the uninformed investors to participate in the IPO offer for better price discovery.

Are IPOs really underpriced?

IPOs have been underpriced by more than 10 percent during the past two decades. Research shows that between 1980 to 1997, the median IPO offer price was higher compared to the stock price of its’ industry peers. The overvaluation ranges from 14 percent to 50 percent, depending on the peer matching criteria.

Research shows that overvalued IPOs provide high first-day returns, and they have low long-run risk-adjusted returns. The overvalued IPOs have lower profitability, higher accruals, and higher growth forecasts than “undervalued” IPOs. Ex post, the projected high growth of overvalued IPOs don’t materialize, while their profitability declines from pre-IPO levels. These results suggest

IPO investors are deceived by optimistic growth forecasts and pay

insufficient attention to profitability in valuing IPOs.

How to analyze and trade shares

Stock research websites are the best place to start researching specific IPOs. Stock analysis websites allow you to set up alerts for specific news about a company. You could set up an alert with the combination of the company name and the term IPO.

As an exchange-listed company, the shares of the company could be good stocks to buy right now. Stock analysis apps can be used for a more extended due diligence process before making the final decision.

Then, you can use the best stock trading apps during the IPO. The chances are that you get some stocks at the original IPO price. Alternatively, you can buy and sell your preferred number of shares on the IPO data or at any time later by using the official stock ticker symbol within your trading platform.

Once invested, you can use your brokerage account, or a stock tracker to manage your positions within the portfolio.

Final Thoughts

Initial public offerings are great for early investors with great potential for long term portfolio performance if the IPO pricing is reasonable. It is in any investor’s interest to check the ownership of a company, collect as much information as possible for a high degree of transparency about all parties involved. There are good reasons to invest in a company early during initial public offerings. A price low might refer to a real buying opportunity, but there is no evidence that this is the case until further due diligence is conducted.

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About the Author

Alexander is the founder of daytradingz.com and has 20 years of experience in the financial markets. He aims to make trading and investing easy to understand for everybody and has been quoted on Benzinga, Business Insider, Investors Business Daily, Newsweek, GOBankingRates, capital.com, investing.com and other major publications.