What is 'Underpricing'
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.
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.
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.