IPO underpricing: a shot in the foot or a strategic move?
An Initial Public Offering is the process whereby a private company sells shares of its stock to the general public for the first time. It is one of the biggest milestones a company will experience, and you would expect that all the care and precision in the world would be used to ensure that nothing goes wrong. And yet, there are cases of companies apparently missing the mark completely with their valuation of themselves: take Airbnb, who priced its 2020 IPO at $68 a share and ended up trading above $144 at the close of their first day. This phenomenon is known as IPO underpricing, which is basically when a company prices its shares for its stock market debut below what investors are willing to pay for it. If you’re wondering, ‘well, what’s the problem? Everyone that invested in it just made a ton of money,’ while that is true for investors, the company itself suffers because it missed out on millions of dollars of capital that it could have earned by pricing their shares nearer to their ‘true value’. Well, how is it possible that they got it so wrong? Was it on purpose? Why would they shoot themselves in the foot like that?
Underpricing > overpricing
As it turns out, there are actually several advantages of pricing an IPO below its expected market value. As it appears more affordable, many retail investors will be attracted to the shares of the company, creating strong investor demand and boosting trading activity. This can help craft the impression of a successful launch for the company, which can generate positive forward momentum for the stock. This is vastly preferable to its stock price falling rapidly on its first day and the IPO being labelled a failure, which is a common result of overpricing (when the stock is priced above its expected market value). Reputationally, it is vastly better to be portrayed as a ‘popular’ stock in high demand than to be known as the company that bombed its debut. After all, if the IPO was underpriced, the stock price simply climbs to the price that investors consider it to be worth. However, a failure to meet expectations makes further fundraising much harder and may drive new and old investors alike away, posing severe consequences for the company.
Explaining IPO underpricing
There is no set formula for determining an IPO’s price. Judging the value of the product, looking at other industry competitors, and inputs from conflicting parties all play a part in the eventual number that investors see on the market. There are a handful of theories about how the lower-than-expected price may come about.
Information asymmetry
There are more uninformed investors than informed investors; informed investors tend to be more cautious and have more information, while uninformed investors are likely to invest based on feelings. There is a problem herein: if IPOs were priced exactly at their "true" value, the well-informed investors would only bother buying when they'd spotted something undervalued, and would sit out the mediocre deals. The less-informed investors, not having that edge, would end up disproportionately stuck with the weaker offerings, potentially discouraging them from investing. To keep ordinary investors participating (which companies need, since institutional demand alone often isn't enough), the IPO has to be priced generously enough to make that risk worth taking.
Institutional (mis)allocation?
Retail investors (like you and me) are not the only people that can affect the performance of IPOs post-listing. A significant portion of shares are also allocated to institutional investors, who are large organisations that invest money on behalf of third-party clients, members, or shareholders. A higher percentage of shares allocated to institutional investors could mean a very limited free float available for public trading, which reduces trading activity and makes it harder for investors to buy or sell larger quantities of shares. IPOs with significant institutional allocations and minor public floats can lead to large price swings. On the flipside, enthusiastic retail participation without sufficient institutional support can also make share prices more volatile, particularly when investor sentiment turns negative. The right balance in allocating shares must be struck by bringing in reputable institutional investors while maintaining a large retail float to diversify the shareholder base and support active trading.
SUMMARY TABLE
ADVANTAGES | DISADVANTAGES |
Helps company raise more capital by increasing demand | Increases transaction cost |
Can cause a spike in price at the beginning of IPO, increasing market sentiment | May signal weakness in the company, increasing concern about its stability |
Attracts more investors (especially retail investors) who participate due to the perceived ‘bargain’ price | Creates expectations for continuous growth, increasing pressure on the company’s management |
Increases liquidity, facilitating the ease of purchase and selling of stocks | Increases price volatility, which may deter some investors |
The big picture
IPO underpricing serves as a good reminder that markets aren’t just cold, robotic and perfectly rational mechanisms. Trust, reputation, competing incentives and politics all play significant roles in determining the value of companies, and these distinctly human elements are wildly unpredictable. In summary, every time you see another company launch their IPO, keep in mind: who won and who didn’t?
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