What is 'Underpricing'

Underpricing is the listing of an initial public offering (IPO) below its market value.  When the offer price of a stock is lower than the price of the first trade, the stock is considered to be underpriced. Typically, a stock is temporarily underpriced because demand will eventually drive it toward its intrinsic value.

BREAKING DOWN 'Underpricing'

An Initial Public Offering (IPO) is the initial offering of stock to the public by a company seeking to raise capital for funding and future growth.  When a company first offer shares to the public, they hope to price them as high as is possible, thereby raising the most capital. Banks and others who are submitting the shares to the floor aim for lower prices. They hope to sell as many shares as is possible, thereby increasing the flow of shares and their profit from trading expenses. Determining the offering price includes many factors with quantitative factors considered first.

Underpricing Quantitative Factors

Quantitative factors include reviewing the financials of the firm bringing the IPO. During this phase, bankers will analyze a firm’s sales, expenses, earnings, and cash flow.  A company’s earnings and expected earnings growth are fundamental aspects of the IPO price. In general, a company will typically trade at a price-to-earnings (P/E) multiple that is comparable to its peers in the industry. The price-to-earnings multiple serves as a basis for valuing the IPO price.

IPO Price

Marketability in a specific industry and the general market also drive the price of an IPO. For example, an expected high demand for the product or general high demand for the IPO market will influence the price. 

Once investment bankers or IPO underwriters determine the price, the company markets the IPO before its first day of trading.  Some reason IPOs are underpriced because of concerns with liquidity and uncertainty about the level at which the stock will trade.

Investors may perceive an IPO as risky because of insufficient historical trading data. The less liquid and predictable an IPO shares are, the more likely it will be underpriced to compensate investors for their assumed risk. Because an IPO's issuer tends to know more about the value of the shares than the investor, a company will underprice its stock to encourage investors to participate in the IPO.

Once exchanged on the open market, the new stock officially becomes publicly traded and owned by shareholders. Shareholder demand will then have control over the stock’s pricing in the open marketplace.

  1. IPO ETF

    An exchange-traded fund that focuses on stocks that have recently ...
  2. Break Issue

    A type of stock initial public offering (IPO) that trades below ...
  3. Bought Deal

    A bought deal is a securities offering in which an investment ...
  4. Hot IPO

    An initial public offering that appeals to many investors and ...
  5. Hot Issue

    An issue that sells at a premium over the public offering price ...
  6. Eating Stock

    The forced purchase of a security when there are insufficient ...
Related Articles
  1. Insurance

    Initial Public Offering (IPO) Explained

    An initial public offering (IPO) marks the start of a company's publicly traded life. Find out why companies undergo IPOs, and how the process works.
  2. Investing

    How To Track Upcoming IPOs

    Interested in investing through IPOs? Here is the list of free sources for information on upcoming IPOs.
  3. 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.
  4. Investing

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

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

    The Ups And Downs Of Initial Public Offerings

    Initial public offerings aren't the best option for every company. Consider these factors before "going public."
  6. Insurance

    4 Hottest IPOs in 2015

    Where is smart money headed this year? These are the most anticipated IPOs of 2015.
  7. Insurance

    IPOs For Beginners

    IPO is one of the few market acronyms that almost everyone is familiar with. Discover if IPOS are worth all the attention.
  8. Investing

    Worst Performing Biotech IPOs of 2016

    Investopedia takes a look at the biotech IPOs of the year 2016, which have resulted in considerable losses so far
  9. Investing

    The Pros And Cons Of A Company Going Public

    Small companies looking for growth often use an initial public offering to raise capital. But going public brings both advantages and disadvantages.
  1. 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 >>
  2. What is the difference between an IPO and a seasoned issue?

    Learn how companies issue IPO securities when they first go public and seasoned issue shares if they sell more shares in ... Read Answer >>
Hot Definitions
  1. Entrepreneur

    An Entrepreneur is an individual who founds and runs a small business and assumes all the risk and reward of the venture. ...
  2. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  3. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  4. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  5. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  6. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
Trading Center