Question

Hello, I am currently working on a case study for my finance course and I do not know what the following question means. I am unsure how to approach it and am looking for any guidance as to how I can start: "Discuss with respect to asymmetry of information how large you believe the underpricing of the IPO should be." Where should I look for necessary info?

Answer 1

Dear Student,

Defination of Under pricing

Under pricing means it is is the practice of listing an initial public offering (IPO) at a price less than its real value in the stock market. When a new stock closes its first day of trading above the set IPO price, the stock is considered to that it have been under priced.

Under pricing is short-lived because investor demand will drive the price upwards to its market value.

Understanding Under pricing

An initial public offering (IPO) is the introduction of a new stock for public trading on a stock exchange. Its purpose is to raise capital for the future growth of the company.

Determining the offering price requires a consideration of many factors. Quantitative factors are considered first. Those are the numbers, real and projected, on cash flow.

KEY TAKEAWAYS

• An IPO may be under priced deliberately in order to boost demand and encourage investors to take a risk on a new company.
• It may be under priced accidentally because its underwriters underestimated the demand in the market for this company's stock.
• In any case, the IPO is considered under priced by the difference between its first-day closing price and its set IPO price.

Nevertheless, there are two opposing goals at play. The company's executives and early investors want to price the shares as high as possible in order to raise the most capital and reward themselves most lavishly. The investment bankers who are advising them may hope to keep the price low in order to sell as many shares as possible since higher volume means higher trading fees for them.

IPO Pricing Factors

IPO pricing is far from an exact science, so under pricing an IPO is equally inexact. The process mixes facts, projections, and comparables:

• Quantitative factors considered include the company's financials including its current sales, expenses, earnings, and cash flow. Projected earnings also are factored in.
• An IPO price that reflects a price-to-earnings (P/E) multiple comparable to the company's industry peers is sought.
• The size of the current and near-future market for the product or service that the company produces is considered.
• The marketability of the company's stock in the current economic environment also is crucial.

Why Underprice?

In theory, any IPO that increases in price on its first day of trading was underpriced, whether it was deliberate or accidental. The shares may have been deliberately underpriced to boost demand. Or, the IPO underwriters may have underestimated investor demand.

Overpricing is much worse than under pricing. A stock that closes its first day below its IPO price will be labeled a failure.

An IPO can be under priced if its sponsors are genuinely uncertain about the reception that the stock will receive. After all, in the bad scenario , the stock price will immediately rise to the price that investors consider that it's worth. Investors willing to take a risk on a new issue are rewarded.

That is considerably better than the company's stock price falling on its first day and its IPO being blasted as a failure.

Whether it was under priced or not, once the IPO debuts the company becomes a publicly traded entity owned by its shareholders. Shareholder demand will determine the stock’s value in the open market going forward.

How Under Pricing Works

When a company decides it wants to issue stock, bonds or other publicly traded securities, it hires an underwriter to manage what is a long and sometimes complicated process.

Determining the final offering price is one of the underwriter’s biggest responsibilities for two reasons. First, the price determines the size of the proceeds to the issuer. Second, it determines how easily the underwriter can sell the securities to buyers. Thus, the issuer and the underwriter work closely together to determine the price.

Once the underwriter is sure it will sell all of the shares in the offering, it closes the offering. Then it purchases all the shares from the company (if the offering is a guaranteed offering), and the issuer receives the proceeds minus the underwriting fees. The underwriters then sell the shares to the subscribers at the offering price. Although the underwriter influences the initial price of the securities, once the subscribers begin selling, the free-market forces of supply and demand dictate the price.

Why It Matters

IPOs are risky propositions for companies, because they involve sophisticated guessing about how much their shares are really worth to other people. Underwriters share in the risk of under pricing an offer, because they ultimately have to sell all the shares at the offer price. Underwriters often mitigate the risk of under pricing by forming a syndicate whose members share a portion of the shares in return for a portion of the fee.

Going public is a great way for many companies to raise capital. Though a bank loan might be an option, it requires monthly principal and interest payments that companies -- especially growing, cash-strapped ones -- may not consider wise uses of cash. Going public solves this problem in a way, because shareholders don't require monthly cash payments -- or any payments, for that matter, unless the company is sold.

Surely this will help you to understand under pricing of an IPO