Underpricing

Introduction

Underpricing is a financial term that refers to the phenomenon where a new stock’s initial public offering (IPO) price is set lower than its market value. This is a common occurrence in equity markets, reducing the cost for investors to buy shares during an IPO, but often at the expense of the issuing company, resulting in a missed opportunity for higher capital inflow.

Causes of Underpricing

1. Asymmetric Information
   • Issuer’s Perspective: Issuers may possess more detailed information about the firm’s true value compared to investors. To counteract this information asymmetry, the price is set lower to ensure investors are compensated for the risk of investing in a potentially overvalued company.
   • Investor’s Perspective: Investors may demand a lower price to protect themselves against the risk arising from the issuer’s superior information.
2. Underwriter’s Incentives
   • Risk Mitigation: Underwriters, who guarantee the IPO by buying the shares themselves if they cannot sell to the public, might prefer underpricing to reduce their risk. They aim to avoid the situation where they are stuck with unsold shares.
   • Reputation Concerns: Reputable underwriters may practice underpricing to ensure a successful IPO. Successful IPOs enhance their reputation, attracting future business.
3. Market Conditions
   • Bull Markets: In bullish market conditions, there is a higher likelihood of underpricing due to increased investor optimism and demand.
   • Bear Markets: Conversely, in bearish markets, underpricing is used to attract risk-averse investors.
4. Regulatory Factors
   • Laws and regulations may also influence IPO pricing strategies, leading companies to adopt conservative pricing approaches to comply with regulatory bodies and avoid potential legal issues.

Methods to Measure Underpricing

1. First-Day Return
   • The difference between the IPO price and the closing price on the first trading day. This return is often used as a direct measure of underpricing.
2. Initial Return
   • The initial return over the first few days or weeks post-IPO is calculated to determine the early performance and extent of underpricing.
3. Price Performance Benchmarking
   • Comparing the IPO price with the average market performance of similar stocks can indicate the level of underpricing.

Consequences of Underpricing

For Issuers

• Loss of Potential Capital: Issuers potentially lose money that could have been raised if the IPO was priced closer to market value.
• Perceived Value: Consistent underpricing might lead to market perceptions of uncertainty about the firm’s true value.

For Investors

• Immediate Gains: Investors who purchase shares at the IPO price and sell them quickly can realize substantial gains.
• Long-Term Holding Risk: Investors may face higher long-term risks if the stock price aligns with the ‘true’ value over time, potentially leading to losses.

For Underwriters

• Commission Benefits: Underwriters benefit from commissions on the volume of shares sold, regardless of the price. High sales volumes due to underpricing add to their revenue.

Examples of Underpricing

Some notable examples of underpriced IPOs include:

1. Facebook (Facebook IPO initially saw significant underpricing in 2012, reflecting high demand and speculative trading post-IPO.)

2. Alibaba (Alibaba’s IPO was underpriced, allowing the stock to surge after its initial listing in 2014.)

3. Snap Inc. (Snapchat’s parent company faced severe underpricing during its IPO in 2017.)

Strategies to Mitigate Underpricing

1. Book Building Approach
   • Involves gathering investor demand at various price levels before setting the final IPO price to reflect market demand more accurately.
2. Dutch Auction
   • Investors bid for shares at prices they are willing to pay. The IPO price is set based on these bids, often minimizing underpricing.
3. Lock-Up Periods
   • Restricts the sale of IPO shares by insiders for a set period, typically 90 to 180 days, providing stability in stock prices post-IPO.

Conclusion

Underpricing is an intricate phenomenon influenced by multiple factors, including information asymmetry, underwriter incentives, and market conditions. While it guarantees demand and mitigates certain risks, it often results in substantial capital loss for issuing companies. Companies and underwriters need to adopt robust strategies like book building and auctions to mitigate the adverse effects of underpricing.

For more insights and research on underpricing, you can visit Nasdaq, which provides extensive articles and updates on IPO performances and financial markets.