What does 'Underpricing' mean

Underpricing is the pricing of an initial public offering (IPO) below its market value. When the offer price is lower than the price of the first trade, the stock is considered to be underpriced. A stock is usually only underpriced temporarily because the laws of supply and demand will eventually drive it toward its intrinsic value.

BREAKING DOWN 'Underpricing'

An IPO is a newly traded stock on the market and as such it may be newly introduced to investors. The proceeds of its sale are used by the company as capital for funding and future growth. The process for arriving at the offering price includes many factors. Quantitative factors are first considered; however, they are not the only factors that lead to the IPO price.

Firm Financials

The main quantitative factors for valuing an initial public offering include the financials of the firm. Bankers review a firm’s sales, expenses, earnings and cash flow. In an IPO valuation pricing, the company’s earnings and expected earnings growth are key aspects of the price. In general, a company will typically trade at a price-to-earnings multiple that is comparable to its peers in the industry. The price-to-earnings multiple serves as a base level to start from when valuing the IPO price.

IPO Price

Additionally, an IPO may be priced based on marketability factors for its specific industry and the market as a whole. If bankers expect a high demand for the product, that will be factored into the price. Also, if there is a high demand for the IPO market in general at the time of the offering that will also help the price.

Once an IPO price is arrived at by the investment bankers or IPO deal leaders, it is marketed prior to its first day of trading at its IPO price. It is believed that IPOs are often underpriced because of concerns relating to liquidity and uncertainty about the level at which the stock will trade.

To investors, an IPO may also be perceived as risky because it does not have historical trading data. The less liquid and less predictable the shares are, the more underpriced they will have to be in order to compensate investors for the risk they are taking. Because an IPO's issuer tends to know more about the value of the shares than the investor, a company must underprice its stock to encourage investors to participate in the IPO.

Once the stock is first traded on the market, it officially becomes publicly traded and owned by the shareholders who purchase the stock. The shareholders then have control over the stock’s pricing in the open market, and the stock’s price will fluctuate greatly from its initial offering price.

RELATED TERMS
  1. Relative Value

    A method of determining an asset's value that takes into account ...
  2. Hot Issue

    An issue that sells at a premium over the public offering price ...
  3. Initial Offering Date

    1. The date at which a security is first made available for public ...
  4. Break Issue

    A type of stock initial public offering (IPO) that trades below ...
  5. Public Offering Price - POP

    The price at which new issues of stock are offered to the public ...
  6. Large-Value Stock

    A type of large-cap stock investment where the intrinsic value ...
Related Articles
  1. Insurance

    How An IPO Is Valued

    The process of determining a company’s initial share price includes quantitative and qualitative components.
  2. Investing

    Top Reasons IPO Valuations Miss The Mark (MS, ZNGA)

    The costly services of investment banks don’t necessarily guarantee accuracy in IPO pricing.
  3. Investing

    Market Volatility, Weak Economy Delay Major IPOs

    These outside factors can delay and affect IPOs when they are finally listed on a stock exchange.
  4. Insights

    Why Are Companies Taking Longer To Go Public?

    Learn why private companies are waiting longer to have their IPOs. Understand why it may be more advantageous for a company to stay private.
  5. Investing

    How The Stock Market Works

    When you buy a stock, you buy a piece of a company.
  6. Investing

    IPOs May Get a Trump Boost in 2017

    The incoming Trump administration is likely to cause the number of U.S. IPOs to surge this year.
  7. Investing

    4 Reasons for the IPO Market Slowdown in 2016 (IPO)

    Pay attention to the length of time a company waits before going public and whether the prolonged period brings excessive valuation.
  8. Investing

    What is a Public Company?

    A public company has sold stock to the public through an initial public offering (IPO) and that stock is currently traded on a public stock exchange.
RELATED FAQS
  1. How can average investors get involved in an IPO?

    An initial public offering, or IPO, is the first sale of stock by a new company, usually a private company trying to go public. ... Read Answer >>
  2. Can mutual funds invest in IPOs?

    Learn whether mutual funds can invest in IPOs. IPO investing is appealing because there is a big upside, but there is considerable ... Read Answer >>
  3. If the intrinsic value of a stock is significantly lower than the market price, should ...

    Discover how the intrinsic value and market price of a stock are related and why a stock that appears overvalued may still ... Read Answer >>
  4. When you buy a stock in a company, does it necessarily mean that one of the shareholders ...

    There are two main markets where securities are transacted: primary and secondary. When stocks are first issued and sold ... Read Answer >>
  5. What does 'going public' mean?

    Going public refers to a private company's initial public offering (IPO), thus becoming a publicly traded and owned entity. ... Read Answer >>
  6. How are share prices set?

    When a company goes public though an initial public offering (IPO), an investment bank evaluates the company's current and ... Read Answer >>
Hot Definitions
  1. Treynor Ratio

    A ratio developed by Jack Treynor that measures returns earned in excess of that which could have been earned on a riskless ...
  2. Buyback

    The repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies ...
  3. Tax Refund

    A tax refund is a refund on taxes paid to an individual or household when the actual tax liability is less than the amount ...
  4. Gross Domestic Product - GDP

    The monetary value of all the finished goods and services produced within a country's borders in a specific time period, ...
  5. Inflation

    The rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of ...
  6. Merchandising

    Merchandising is any act of promoting goods or services for retail sale, including marketing strategies, display design and ...
Trading Center