Underpricing is the IPO strategy of issuing IPO shares below their real value in the market. The shares are considered underpriced when the new shares close above the actual IPO price after the first day of trading. When the listing company releases shares at a lower price, its primary goal is to attract more investors. Underpriced IPO shares create an opportunity for the existing shareholders to liquidate their holdings and exit the investment. However, the underpricing strategy is effective only for a short time, before the investors’ demand pushes the price up.
For IPO investors, underpriced IPOs present a compelling opportunity to invest in new companies. In this article, we will understand what an underpriced IPO is and how underpriced IPOs can yield significant returns for savvy investors.
What Is an Underpriced IPO?
Underpricing is a situation where the company’s IPO share price is set below its actual market value. It can occur for two reasons – when the IPO is priced conservatively to make the offer attractive to investors or when there is a mispricing of the share price by the underwriter.
Underpricing is a technique used by companies in trouble to make their shares attractive. The company keeps the share price below its actual price. However, the stock value increases after the first day of trading as the market corrects itself.
Underpricing of IPO shares can result from information asymmetry, legal court proceedings, or as a technique to boost demand due to a lower price.
Here is the formula to calculate underpriced shares.
Underpriced cost = [(Pm-P0) / P0] * 100
Where,
Pm= Price at the end of the first trading session
P0= Offering price
Underpricing is denoted as a percentage and, hence, multiplied by 100.
Let’s understand IPO underpricing with an example.
Suppose a company has released its shares at ₹90. It is the offering price, or P0, of the IPO shares. At the end of the trading session, the company’s shares rose to ₹150. It is the closing price.
According to the above-mentioned formula, the underpricing cost is calculated as below.
Undervalued cost= 150-90 / 90 * 100 = 66.66%. Hence, the stock was 66.66% underpriced.
IPO underpricing often arises from offering price calculation errors. There are several quantitative and qualitative factors responsible for IPO pricing. The quantitative factors include the company’s financials, projected and real numbers, and cash flow mentioned by the company. Based on these factors, when companies enrol on the stock exchange, they can either list shares at the original price or at a lower price. Once the stocks are listed, their prices start to rise. Hence, the underpriced situation may not last for a longer period, and by the end of the first day’s trading session, the company’s stocks will adjust to their actual value.
Reasons for IPO Underpricing
IPO is the process of introducing a new company to the stock exchange. The primary target of the company is to raise capital.
Sometimes underpricing can happen accidentally when the underwriter underestimates the demand for a company’s stocks. Conversely, sometimes underpricing is a deliberate strategy to encourage investors to take risks with a new company. Researchers have highlighted a few theories behind underpricing.
Information asymmetry: Information disparity can arise due to differences in available
information between the issuer and investors. The theory suggests that there are more uninformed investors than informed investors. Informed investors will only invest when they are sure of getting returns from their investment, but uninformed investors may invest randomly. However, since an underwriter’s success depends on the number of investors bidding for the offer, they need uninformed investors to continue bidding. The underwriter may keep the offer price low to cut the losses of these investors.
Agency conflicts: This happens between the company and the underwriting agency.
In the case of an IPO, underpricing increases the cost of the IPO for the company but benefits the underwriter. Underpricing translates into more demand, and more demand for the IPO shares will result in more commission for the underwriter.
Publicity: Another reason for issuing underpriced stocks is to get publicity. Deeply discounted IPO stocks often make it to the front page of newspapers.
Legal issues: Legal liabilities and negative news may also be motivations for IPO underpricing. If a company undergoes legal proceedings, it may tarnish its reputation. However, it may attract high-risk investors if the stock is underpriced.
Why Is Underpricing Important?
From an investor’s perspective, if the stock is oversold, it is undervalued. When a market security is sold repeatedly, its price hits rock bottom, and investors always look for oversold stocks to buy at a lower price and sell at a higher price. However, the low price is a short-lived condition, and soon the price will hike as the market adjusts itself, resulting in significant gains for investors who invested at a lower price.
Advantages and Disadvantages of IPO Underpricing
IPO underpricing presents an excellent opportunity for existing shareholders to exit their investments. However, on the flip side, underpriced IPOs increase the transaction cost. We have listed below the advantages and disadvantages of underpricing an IPO.
| Advantages | Disadvantages |
| Helps a company raise more capital from its IPO activity by increasing demand | The company must undertake and fulfil all disclosure requirements |
| It allows the existing shareholders to exit their investment | The underpricing activity will increase the transaction cost |
| Underpriced stocks can experience a spike in price at the beginning, which can create positive market sentiment | Underpricing can signal significant weakness in the company or undervaluation, which can increase concerns about its financial stability |
| Underpricing may attract a variety of investors, including retail investors who may participate due to bargain price | Underpricing creates expectations for continuous growth, which may result in increased pressure on the management. |
| Underpricing can increase liquidity and investors can buy or sell the stocks easily | It can significantly increase price volatility, during the early trading days, making it difficult for investors to navigate |
Final Words
Underpricing an IPO is a well-practised tactic for artificially boosting demand for IPO shares at attractive prices. In theory, any IPO that increases in price on the first day of trading is underpriced. It can either be deliberate or accidental. If you are interested in investing in IPOs, understanding the concept will help you evaluate a proposal better.
FAQs
What is IPO underpricing?
IPO underpricing is the tactic of introducing IPO shares to investors at a lower price than their actual value. An IPO is said to be unpriced when its value increases at the end of the first day of trading or the share’s closing price is higher than the offer price.
Who benefits from IPO underpricing?
Underpriced IPOs have an impact on the existing shareholders, the underwriting company or investment bank, and investors.
- • It presents the existing shareholders with the perfect opportunity to exit their investment
- • The underwriting company may gain in terms of more commission
- • Investors may benefit from a discounted price
How does underpricing an IPO impact the company raising funds?
The company may receive less capital than it could have if the IPO was priced higher. It may impact the company’s ability to fuel future growth and expansion.
What are the potential risks of participating in an underpriced IPO?
Underpriced IPO stocks may experience significant volatility at the beginning of their trading. Also, it increases the possibility of missing the IPO allotment due to oversubscription.
Do underpriced IPOs always lead to higher returns for investors?
IPO underpricing may not guarantee higher returns. The stock’s long-term performance depends on factors including the company’s financial health, market conditions, and its ability to execute its business plans.
