Definition
IPO underpricing refers to the phenomenon where a company’s initial public offering (IPO) shares are priced below their market value, as evidenced by a significant increase in share price on the first day of trading. This underpricing is calculated as the difference between the closing price of the stocks on the first day of trading and the offering price, expressed as a percentage of the offering price.
Mechanisms of IPO Underpricing
Pricing Strategies
Investment banks, who typically underwrite IPOs, may deliberately set the offer price lower than the expected market price to ensure that the IPO is fully subscribed. This can create a sense of urgency among investors and help mitigate the risk of unsold shares.
Market Sentiment
The market’s enthusiasm and demand can lead to underpricing. If investors believe the company has strong growth potential, the demand might outstrip the IPO supply, indirectly causing underpricing.
Reasons for Underpricing
Reduced Risk for Underwriters
Underwriters are responsible for selling the IPO shares and bear the risk of unsold shares. By underpricing, they can ensure full subscription, reducing their risk.
Creating Positive Market Sentiment
A significant increase in share price post-IPO can create a buzz and positive sentiment around the company, enhancing its public image and future trading stability.
Legal and Regulatory Considerations
Certain jurisdictions require IPOs to be underpriced to protect retail investors from potential losses. This legal framework ensures a balanced approach to market entry for new companies.
Examples of IPO Underpricing
Historical Examples
- Google: When Google went public in 2004, its shares were priced at $85, but they closed at $100.34, a 17.4% increase on the first day.
- Facebook: Initially priced at $38 per share during its 2012 IPO, Facebook’s stock price saw a modest first-day increase, but the following days showed more volatility, offering a different perspective on underpricing’s impact.
Related Terms
- Initial Public Offering (IPO): An IPO is the process by which a private company offers its shares to the public for the first time, usually to raise capital for expansion.
- Underwriters: Underwriters are financial specialists and institutions that assess the risk and manage the issuance of securities, helping companies navigate the IPO process.
- Flipping: Flipping refers to the practice of buying IPO shares at the offer price and selling them immediately upon market open to capitalize on underpricing.
FAQs
Why do companies allow underpricing in their IPOs?
How is IPO underpricing calculated?
Underpricing is calculated as follows:
Is IPO underpricing beneficial for investors?
Summary
IPO underpricing is a strategic approach employed during a company’s initial public offering to ensure share subscription, create positive market sentiment, and manage underwriting risks. While beneficial for investors, it must be carefully managed to balance company interests and market perceptions.
References
- Ritter, Jay R. “Initial Public Offerings: Underpricing.” Journal of Finance.
- Ibbotson, Roger G. “Price Performance of Common Stock New Issues.” Journal of Financial Economics.
- Aggarwal, Reena, and Purnanandam, Amiyatosh. “Pricing and Performance of IPOs.” Journal of Financial Management.
Crafted with precision, this article demystifies IPO underpricing and its implications in the financial ecosystem. Let this be your definitive guide.
