IPO Underpricing: Evidence & Reasons

Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

After reading this lesson, you will have a better understanding of why some businesses decide to underprice themselves when they first begin offering company shares for sale on the stock market.

IPOs

A company's first offer of shares for sale on the stock market is called an IPO or an initial public offering. When investors purchase the IPO shares, they are giving the company money to work with.

While most companies set their IPO price per share to what their company is worth, not all companies do so.

Underpricing

Some companies underprice their IPO, meaning it is priced below market value. They have decided to price their shares to reflect a market value less than the company is currently worth. For example, a company has a current market value of $850,000. It decides to price its IPO at $5.00 per share. The IPO has a total of 150,000 shares. At this IPO price, the company has valued itself at $5.00 * 150,000 = $750,000. That's $100,000 less than its current market value.

Theories

Why do companies do this? There are several theories.

One, referred to as the information asymmetry theory, is that the majority of investors are uninformed investors who don't care about the quality of the IPO they are investing in. These investors do not fully understand IPO quality. They simply invest in companies that they can afford, not necessarily those companies that will perform well for them. These investors either don't have the necessary information or simply aren't interested in knowing what kind of company they are investing in. They just want something that will give them a good return on their investment. Companies may decide to underprice so that they attract these uninformed investors, because, if they don't, there may not be enough informed investors out there who will buy up all the shares of that company's IPO.

Another theory, called the investment bank conflict theory, says that some investment banks encourage underpricing because it a benefit to them. This happens more when banks don't charge a high enough underwriting fee.

There are other theories out there, but we won't discuss them here.

Evidence

Both the information asymmetry theory and the investment bank conflict theory can be seen at work in studies of IPOs. These studies have found that when there are enough informed investors, the amount of underpricing goes down. And, if banks charge a high enough underwriting fee, underpricing has been seen to go down as well.

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