Initial Public Offerings (IPOs) have long fascinated investors, academics, and financial professionals. One of the most intriguing aspects of IPOs is the phenomenon of underpricing, where shares are sold at a price lower than their market value on the first day of trading. This article explores the underpricing theory in IPOs, delving into its causes, implications, and the mathematical models that explain it. I will also provide examples, comparisons, and insights into how this phenomenon impacts the US financial markets.
Table of Contents
What is IPO Underpricing?
IPO underpricing occurs when the offer price of a stock is set lower than its closing price on the first day of trading. For example, if a company sets its IPO price at $20 per share, but the stock closes at $25 on the first trading day, the underpricing is $5 per share, or 25\%. This discrepancy has been observed across global markets, but it is particularly pronounced in the US.
Underpricing is not a random occurrence. It is a deliberate strategy influenced by various economic, psychological, and institutional factors. To understand why underpricing happens, I will explore the theories and models that explain this phenomenon.
Theories Behind IPO Underpricing
1. Information Asymmetry Theory
One of the most widely accepted explanations for IPO underpricing is information asymmetry. This theory, proposed by Rock (1986), suggests that underpricing compensates less-informed investors for the risk of investing in a company with uncertain prospects. In this model, there are two types of investors:
- Informed investors: These investors have access to detailed information about the company and its prospects. They only participate in IPOs they believe are undervalued.
- Uninformed investors: These investors lack detailed information and participate in all IPOs, regardless of quality.
Because informed investors avoid overpriced IPOs, uninformed investors are left with a disproportionate share of overpriced offerings. To attract uninformed investors, underwriters set the IPO price lower than the expected market value, ensuring a first-day “pop” that benefits all participants.
The mathematical representation of this theory can be expressed as:
P_0 = E[P_1] - \frac{\alpha}{1-\alpha} \cdot \text{Risk Premium}Where:
- P_0 is the IPO offer price.
- E[P_1] is the expected market price on the first trading day.
- \alpha is the proportion of uninformed investors.
- The risk premium compensates uninformed investors for the adverse selection risk.
2. Signaling Theory
Another explanation for underpricing is the signaling theory, proposed by Allen and Faulhaber (1989). This theory suggests that high-quality firms underprice their IPOs to signal their quality to the market. By leaving money on the table, these firms demonstrate their confidence in future performance, which can lead to higher valuations in subsequent offerings.
For example, a tech startup might underprice its IPO to signal its growth potential. Investors interpret this as a sign of confidence, leading to increased demand and higher prices in the aftermarket.
3. Institutional Theory
Institutional factors also play a significant role in IPO underpricing. In the US, investment banks often underprice IPOs to maintain relationships with institutional investors, who are their primary clients. By offering shares at a discount, banks ensure that their clients achieve substantial returns, fostering goodwill and future business.
4. Behavioral Finance Perspective
Behavioral finance offers a different angle, suggesting that underpricing is driven by investor psychology. The “winner’s curse” phenomenon, where investors overbid for shares due to over-optimism, can lead to underpricing. Additionally, the “anchoring effect” causes investors to rely heavily on the IPO price as a reference point, leading to irrational exuberance in the aftermarket.
Mathematical Models of IPO Underpricing
To quantify underpricing, I use the following formula:
\text{Underpricing} = \frac{P_1 - P_0}{P_0} \times 100\%Where:
- P_1 is the closing price on the first trading day.
- P_0 is the IPO offer price.
For example, if a company’s IPO price is $20 and the stock closes at $25 on the first day, the underpricing is:
\frac{25 - 20}{20} \times 100\% = 25\%Example Calculation
Let’s consider a hypothetical IPO:
- IPO Price (P_0): $30
- First-Day Closing Price (P_1): $36
Using the formula:
\frac{36 - 30}{30} \times 100\% = 20\%This means the IPO is underpriced by 20\%.
Empirical Evidence of Underpricing in the US
Underpricing is a well-documented phenomenon in the US. According to a study by Ritter (1991), the average underpricing of US IPOs between 1960 and 1990 was 16.4\%. More recent data from Jay Ritter’s updated research shows that underpricing has increased, with the average first-day return exceeding 20\% in the 2010s.
Table 1: Average IPO Underpricing in the US (1960-2020)
| Decade | Average Underpricing |
|---|---|
| 1960-1970 | 12.5\% |
| 1970-1980 | 14.8\% |
| 1980-1990 | 16.4\% |
| 1990-2000 | 18.2\% |
| 2000-2010 | 19.7\% |
| 2010-2020 | 21.3\% |
This table illustrates the increasing trend of underpricing over the decades, reflecting changes in market dynamics and investor behavior.
Implications of IPO Underpricing
For Companies
Underpricing represents a significant cost for companies going public. By selling shares below their market value, companies leave money on the table, reducing the capital they could have raised. For example, if a company sells 10 million shares at $20 instead of $25, it loses $50 million in potential proceeds.
However, underpricing can also benefit companies by creating positive market sentiment, attracting media attention, and facilitating future capital raises.
For Investors
For investors, underpricing offers an opportunity to achieve substantial returns on the first day of trading. However, it also introduces risks, as the initial price surge may not be sustainable in the long term.
For the Market
Underpricing can distort market efficiency by creating artificial demand and inflating stock prices. This can lead to speculative bubbles, as seen during the dot-com boom of the late 1990s.
Case Study: The Facebook IPO
The Facebook IPO in 2012 provides an interesting case study. Initially priced at $38, the stock closed at $38.23 on the first day, representing minimal underpricing. However, the stock price declined in the following months, raising questions about the accuracy of the IPO pricing.
This example highlights the challenges of pricing IPOs accurately and the potential consequences of over- or underpricing.
Conclusion
IPO underpricing is a complex phenomenon influenced by information asymmetry, signaling, institutional factors, and behavioral biases. While it offers short-term benefits to investors, it represents a significant cost for companies and can distort market efficiency. By understanding the theories and models behind underpricing, investors and financial professionals can make more informed decisions in the IPO market.
