Big Tech and Recent IPOs

All You Need To Know About IPOs Underpricing

Aakriti

4th Oct'22
All You Need To Know About IPOs Underpricing | OpenGrowth

Have you ever wondered what are Initial Public offerings ( IPOs) underpriced, even for big companies? Are IPOs really underpriced? How to find a good IPO and when to invest in it?

 

Well, here is an answer you might not have expected.

Every year, several companies raise capital with the careful assistance of investment bankers. Investment bankers help companies issue securities and access more funds. The problem is that when these companies access the capital markets, they are growing at an extraordinary pace. This means that these companies have many simultaneous ventures that require money. These financial requirements can not be fulfilled by traditional means of funding, for example, promoter's equity or bank loans. So these companies turn toward capital markets in a hurry.

 

It is very well known that when these companies sell their securities, they often price themselves less. Hence, when IPOs are issued, they are significantly underpriced. This trend is emerging worldwide, even though capital markets are, without exception, highly competitive all around the world, and therefore any price discrepancies should be fixed immediately. It is good that the companies issuing securities are leaving some money on the table! 

 

Let us try and understand,

  • What is underpricing?

  • Are IPOs really underpriced?

  • Why do underwriters usually underprice IPOs?

 

IPO graphics


What Is Underpricing?

 

When an Initial Public Offering or IPO is priced at a value that is less than its actual value in the stock market, it is considered underpriced. So when any new stock closes its first day in the stock market above the price that it was valued at, the stock is considered to have been underpriced. Underpricing is fugacious as the investor demand drives the price up to its market value.

 

Understanding Underpricing

 

An initial public offering (IPO) is a new stock on a stock exchange. The purpose of an IPO is to raise capital for the future expansion and growth of a company. In order to determine the right offering price, many factors need to be examined carefully. At first, the quantitative factors are considered, such as the numbers, real and projected, on cash flow.

 

It is in favor of the early investors and the executives of the company to price the shares as high as possible so as to raise the most capital and reward themselves most lavishly. On the other hand, the investment bankers who are advising them may wish to keep the price of the stocks low to sell more shares as higher volume means higher trading fees for them.

 

IPO Pricing Factors

 

One might think that there will be an exact formula to price or rather underprice an IPO, but the contrary is true.IPO pricing is far from being an exact science and hence underpricing an IPO is equally inexact. The process of pricing an IPO is comprised of mixed facts, projections, and comparables:

 

  • Quantitative factors: These include the company's financials, including its current sales, expenses, earnings, and cash flow. Projected earnings are factored in as well.

  • P/E: An IPO price that reflects a price-to-earnings (P/E), multiple comparables to the company's industry peers are examined.

  • Size of the market: The size of the current and future market for that the company's product/service is considered.

  • The marketability of the company's stock in the current economic environment also is crucial.

 

Why underprice IPOs?

 

According to formal studies that have been conducted by many organizations to help precisely understand why Initial Public Offering(s) (IPOs) are underpriced, the following 4 major factors are to blame - 

1. The monopoly of Investment Bankers

 

Various studies have argued that since investment banks had a monopoly on the underwriting of shares, the IPOs were being underpriced. 

This happened because the investment bankers have an incentive to underprice the stocks/shares. When the price of shares is lower than the market price, there is a much higher probability that the investment banker will be able to sell all the shares quite easily. 

Whereas, if the stocks/shares are priced as per the market, there are fair chances that all the shares might not sell at once. Hence, in accordance with the underwriting clause, the investment bank will have to hold on to some of the shares on their books. This would entail that their own capital gets locked, and they have to undertake the risks. 

 

This is the reason why underpricing the stocks works in favor of investment bankers. Although investment bankers have been arguing that this is not accurate since they do not hold a monopoly over the underwriting of shares anymore. Ever since the Glass Steagall Act was repealed, commercial banks, foreign banks, and a wide variety of institutions have had the ability to underwrite shares. 

 

Therefore, it is logical to assume that the competition amongst various underwriters ideally eliminates the underpricing of shares.


 

2. Protection from Lawsuits 

 

There are other reasons why Investment bankers might underprice IPOs. As per security regulations in many countries, the investment banker is liable for losses that might arise from any misinformation from the investment banker's end. So if it gets proven in a court of law that the stocks sold were wrongly overpriced, then the investment banker could face huge liability for the same.

To remedy this, investment bankers assume that the heads of the selling company are not providing them with 100% accurate information. Therefore they lower the valuation on purpose and keep a spread for themselves and underprice the shares. 

This is more like a precautionary measure so that even if adverse information is found out, later on, the investment bankers can still argue that the stocks are not overpriced, even when considering the new information. Therefore they are not liable to pay any damages to the shareholders.

 

So all of this still serves as a point of conflict of interest. The fact of the matter is that- to save themselves from potential lawsuits, investment bankers do have a motivation to provide a lower valuation to the seller company's shares.

 

3. Information Asymmetry

 

stats and graphics spread on a surface

The huge information asymmetry that exists during an IPO can not be ignored when discussing the pricing of an IPO. When an IPO process is announced, the investors buy into a relatively unknown commodity. Prior to the IPO, the business of the company has been private. This means that their financial performance till then has not been disclosed to the public.

 

Although the IPO process requires the disclosure of the (seller) company's financial performance from the past few years, there still remains a huge information asymmetry. This is a reason why bidders always bid at a lower price. Another reason is that they will bid on many IPOs on average, and some issues might turn out to be overpriced. Hence, just to be careful, investors bid a lower price on an IPO.

 

This is no secret to the selling company as well. But they do not seem to protest. They know that once the IPO has been issued and proves to be worthwhile, the investing community will provide a better valuation for the subsequent public offerings. 

 

In other words, we might say that underpricing is sort of a premium that the selling company has to pay in order to induce the investors to bet their money on an unknown company.

 

4. Insider Outsider Theory

 

The insider-outsider theory assumes that underpricing is the best strategy given the asymmetry. This theory suggests that if the issue is underpriced, the insiders will still buy it because they are aware of its real value. While the outsiders will buy it, assuming that it is at least a fair value. 

 

As the market corrects and prices rise, both insiders and outsiders will profit. Alternatively, if the issue is overpriced, then nobody would want to buy it, as insiders would know the real value, while outsiders would hesitate to invest given the high price.

 

Conclusion

 

wooden blocks and a jar of money on a table

 

To conclude, though the underpricing of IPOs might seem like an anomaly, it really is not. It rather is a strategy that has been used by companies as a marketing tool for their issues.


 

So what do you think now? Are IPOs really underpriced?

Well, I hope this article helped you in understand how IPOs are priced. By avoiding the IPO pitfalls and increasing your general understanding of IPO, you can begin your investing journey in no time.

 

We at OpenGrowth, are committed to keeping you updated with the best content on the latest trendy topics from any major field. Also, both your feedback and suggestions are valuable to us. So, do share them in the comment section below.

A student in more ways than one. Trying to feed her curiosity with news, philosophy, and social commentary. 

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