Underpricing

What Is Underpricing?

Underpricing, in the context of corporate finance, refers to the practice of setting the initial public offering (IPO) price of a company's shares below their true market value, or below the price at which they begin trading in the secondary market. This phenomenon, most commonly observed in Initial Public Offerings (IPOs), results in the stock price experiencing a significant "pop" or increase on its first day of trading. The difference between the offer price and the closing price on the first trading day is often seen as the degree of underpricing. While seemingly counterintuitive for a company seeking to maximize capital raised, underpricing is a common strategy employed by investment bank syndicates to ensure the success and widespread investor interest in a new public offering.

History and Origin

The phenomenon of underpricing in new issues has been observed for decades. Early academic research, such as that by Roger Ibbotson in the 1970s, documented its consistent presence in the U.S. capital markets. Ibbotson's 1975 study, for example, found an average underpricing rate of 11.4% for U.S. new issues between 1960 and 1969.¹⁶ Jay R. Ritter, a prominent finance professor, has extensively studied IPO underpricing data, consistently showing positive average first-day returns for IPOs over many years.¹³, ¹⁴, ¹⁵

Historically, underpricing has been linked to various market conditions and behaviors. During the dot-com bubble of the late 1990s and early 2000s, IPO underpricing reached extreme levels, with some offerings doubling or more on their first day of trading.¹¹, ¹² This period highlighted how strong investor exuberance and the desire to secure allocations in "hot" IPOs could lead to significant first-day price surges. The consistent observation of underpricing over different market cycles has led to numerous theories attempting to explain its persistence.¹⁰

Key Takeaways

• Underpricing occurs when a newly issued stock, particularly an IPO, is priced below its market value, leading to a first-day trading gain.
• It is a common feature of public offerings, often deliberately engineered by underwriters.
• The primary goal of underpricing is to generate investor demand and ensure a successful offering.
• While it can leave "money on the table" for the issuing company, it can also create goodwill with initial investors.
• Various theories, including asymmetric information and signaling, attempt to explain the persistence of underpricing.

Formula and Calculation

Underpricing is typically quantified as the percentage difference between the closing price on the first day of trading and the initial offer price. This is also referred to as the initial return.

The formula for calculating underpricing (initial return) is:

Where:

• First Day Closing Price is the share price at the end of the first day of public trading.
• Offer Price is the price at which the shares were initially sold to investors in the primary market.

Interpreting the Underpricing

Interpreting underpricing involves understanding its implications for both the issuing company and investors. A positive underpricing percentage indicates that the stock performed well on its first day, rewarding initial investors with an immediate paper gain. From an investor's perspective, this is often seen as a favorable outcome, as it offers a quick profit opportunity for those who successfully obtain shares in the IPO. This can lead to increased investor interest and a perception of a "hot" issue.

For the issuing company, while underpricing means they raised less capital than they potentially could have, it can be a strategic choice. It aims to create positive momentum for the stock, attract a broad investor base, and build goodwill, which can be beneficial for future capital raises or market perception. However, excessive underpricing can be viewed as the company "leaving money on the table," foregoing potential proceeds that could have been used for growth or debt reduction. The level of underpricing often reflects the uncertainty surrounding a company's valuation and the market's demand for its shares at the time of the offering.

Hypothetical Example

Imagine "GreenTech Innovations Inc." decides to go public. After working with its investment bank, they set the Initial Public Offering (IPO) price at $20 per share. On the first day of trading on the stock exchange, strong investor demand pushes the share price up rapidly. By the end of the first trading day, GreenTech Innovations Inc.'s stock closes at $26 per share.

To calculate the underpricing:

• Offer Price = $20
• First Day Closing Price = $26

In this hypothetical example, GreenTech Innovations Inc.'s IPO was underpriced by 30%, meaning initial investors who bought at the offer price saw an immediate 30% gain on their investment by the end of the first day. This immediate gain is often referred to as the "first-day pop."

Practical Applications

Underpricing is most prominently discussed in the context of Initial Public Offerings (IPOs) but its principles can apply to other forms of equity financing.

1. Initial Public Offerings (IPOs): The most direct application. Underwriters, often a syndicate of investment banks, work with the issuing company to set the offer price. A common explanation for underpricing in IPOs is the need to compensate investors for the inherent risk premium associated with new, unproven companies and to mitigate the "winner's curse" problem, where uninformed investors might only receive allocations of overpriced issues.⁸, ⁹ The Securities and Exchange Commission (SEC) oversees the IPO process, ensuring proper disclosure, though pricing itself is a market-driven negotiation.⁶, ⁷
2. Generating Demand: A strategically underpriced IPO creates high demand, often leading to oversubscription. This ensures that all shares are sold, even for companies with less established reputations, and can foster a positive initial perception in the market.
3. Investor Relations: Rewarding early investors with immediate gains can build a positive relationship between the company and its new shareholders. This goodwill can be valuable for future fundraising or in times of market volatility.
4. Market Signaling: Some theories suggest that underpricing acts as a signal of the issuing company's quality. A high-quality firm might underprice its IPO to demonstrate confidence in its long-term prospects, anticipating that strong aftermarket performance will validate its decision.

Limitations and Criticisms

While underpricing serves strategic purposes, it is not without limitations and criticisms.

One significant criticism is the "money left on the table" argument. When an IPO is underpriced, the issuing company receives less capital than it could have if the shares were priced closer to their true market value. For instance, studies have estimated that significant amounts of potential proceeds have been foregone by companies due to underpricing.⁵ This can be a substantial cost, especially for companies looking to raise maximum capital for growth or debt reduction.

Another limitation stems from information asymmetry. Investment banks, through the book-building process, gather information about investor demand. Critics argue that underwriters might have an incentive to underprice to make the offering more attractive to their institutional clients, potentially at the expense of the issuing firm. This conflict of interest, where underwriters act as agents for the issuer but also manage relationships with large buyers, is a long-standing debate.³, ⁴

Furthermore, underpricing can contribute to market inefficiencies. While the immediate "pop" is often celebrated, research also suggests that IPOs can experience long-term underperformance relative to comparable seasoned companies.¹, ² This raises questions about the long-term benefit of aggressive underpricing if the initial enthusiasm does not translate into sustained post-IPO success and stable market efficiency.

Underpricing vs. Initial Public Offering (IPO)

While closely related, "underpricing" and "Initial Public Offering" refer to distinct concepts in finance.

An Initial Public Offering (IPO) is the process by which a private company first offers shares of its stock to the general public. It marks the transition of a company from private to public ownership, allowing it to raise capital from public investors and list its shares on a stock exchange. The IPO process involves extensive regulatory filings, such as a prospectus, and the involvement of investment banks to facilitate the offering and manage flotation costs.

Underpricing, conversely, is a specific characteristic or outcome often observed within the IPO process. It describes the situation where the initial offer price of the shares is set below the price at which the shares subsequently trade in the public market, particularly on their first day. An IPO can occur without underpricing (though it is rare for there to be zero first-day pop), but underpricing, by definition, is a phenomenon directly tied to the pricing and initial trading of new public shares. Essentially, the IPO is the event of going public, while underpricing is a common result or strategy employed during that event.

FAQs

Why do companies underprice their IPOs?

Companies often underprice their Initial Public Offering (IPO) to ensure the offering's success, generate strong investor demand, and create positive momentum for the stock. This strategy aims to build goodwill with initial investors by offering them an immediate gain, which can be beneficial for the company's long-term relationship with the capital markets. It can also compensate investors for the inherent risk and information asymmetry associated with buying shares in a new, unproven public company.

Is underpricing good for investors?

Generally, yes, underpricing is considered good for investors who successfully acquire shares at the offer price, as it typically results in an immediate paper profit on the first day of trading. This "first-day pop" can be attractive, but it does not guarantee long-term investment success.

Does underpricing always happen with IPOs?

Underpricing is a very common phenomenon in Initial Public Offerings globally, with studies consistently showing positive average first-day returns. However, it does not happen in every single IPO. Some IPOs may trade flat or even below their offer price on the first day, although this is less common for well-managed offerings.

How does underpricing affect the company issuing shares?

For the company issuing shares, underpricing means they raise less capital than they might have if the shares were priced higher. This is often referred to as "leaving money on the table." While it sacrifices potential immediate proceeds, it can contribute to a successful market debut, positive investor sentiment, and increased liquidity for the stock, which can be beneficial in the long run.

Can underpricing be predicted?

Predicting the exact degree of underpricing is challenging due to complex market dynamics, investor sentiment, and information disparities. However, factors such as market conditions, industry trends, the reputation of the investment bank underwriting the IPO, and the company's own financial strength can influence the likelihood and extent of underpricing.