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 offers shares to the public, it hopes to price them as high as 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 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.
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 reasons IPOs are underpriced are 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's shares are, the more likely they 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.