What is Underpricing?
Underpricing is a phenomenon in the finance world where a company, going for IPO (initial public offering), prices its shares below its real value. A stock is said to be underpriced if, on its first day of trading, it closes above the set IPO price. For example, eBay, on its first trading day in 1998, closed at $47.38, well above the offer price of $18.
A point to note is that the underpricing does not stay for long. Following the IPO, the demand for the investors will eventually push the price of the stock up to its market value. One may also say that such a phenomenon goes against the concept of market efficiency. Despite this, this trend of underpricing is present universally, including in developed and developing countries.
- What is Underpricing?
- Underpricing Formula
- IPO Pricing and Underpricing
- Reasons for Underpricing
- Final Words
The basic formula for calculating underpricing is
Here Pm is the price of the stock at the end of the first trading day, and Po is the offering price.
How to Calculate Underpricing Percentage?
For example, 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%.
IPO Pricing and Underpricing
Pricing of IPO is a complicated process that involves several factors, such as cash flows (real and projected), the reputation of a company, the reputation of underwriters, auditors, and more. Apart from these, the intentions of the parties involved with the IPO process also play their parts.
For instance, the management and early investors would want to price the IPO as high as possible to raise more capital. This also increases the value of their investment in the company. On the other hand, an investment banker usually would want to keep the pricing lower so that they could sell more shares and earn higher fees.
Thus, we can say that the investment bank plays a significant role when deciding about IPO underpricing. And, it is the underwriter or the management or both that usually benefit from underpricing the shares.
More reasons explain why a company would want to underprice its shares. These reasons are discussed below.
Reasons for Underpricing
Following are some of the theories that explain why a company ends up setting a price lower than the market price and why will underpricing persist in the market?. Just try to understand who all can benefit from IPO Underpricing?
Information Asymmetry Theory
This theory says that most of the investors don’t have access to adequate information on the IPO. Moreover, such investors don’t care and understand the quality of the IPO as well. Their only concern is affordability. Meaning, they want to invest in the IPO that they can afford and the one that could give them good returns. Thus, to attract such investors, companies underprice their shares. This theory assumes that there are more uninformed investors than informed ones.
Investment Bank Conflict Theory
As per this theory, some investment bank encourages companies to keep the IPO price lower. The investment banks usually do so when they keep the underwriting fee to a minimum. Thus, a lower price per share helps them compensate for the lower underwriting fee.
Unclear on Public Demand
If the company and the underwriters do not have a clear idea about the demand for the stock, then they go with IPO underpricing. This is the best option given the circumstances. If they price it lower and there is more demand, the stock will anyway rise to its fair value, rewarding both investors and the management.
On the other hand, if the management is unclear about the demand, yet they price it at its fair value, it may result in the stock price falling on the first trading day. This could force many to tag the IPO as a failure.
As per this hypothesis, some investors are unable to get the share during the IPO (due to oversubscription). Such investors try to buy stocks when it lists on the market, thereby leading to a speculative price rise. Something similar was seen during the IT boom phase.
This theory assumes that management hypes the IPO so that they can sell the shares once the official lock-up terms expire. At the same time, management also underprices the share to ensure enough buyers.
Litigiousness and Regulation
US securities laws are stringent on the issuer and the underwriter in case of any material misstatements and omissions in the IPO. So, to keep them safe from such a misstatement or omission, the issuer and the underwriter intentionally underprice the IPO. This makes sure that even if there is any failure (or failures) on the part of the issuer or underwriter, the buyer does not get to benefit from it as these are already priced in the IPO.
Even though underpricing is an important IPO concept, it is for the short term, as we said above. Once the stock – overpriced or underpriced – lists on the exchange, the demand and supply factors quickly bring it to its fair value.