Underpricing
The term refers to a situation in the course of the initial public offering of a stock where, at the end of the first day of trading, the price of the stock is larger than the set IPO price
In this scenario, investors believe that the set price of the listing is below the real market value of the IPO. Upon spotting mispricing, investors are quick to take advantage of the discounted price and quickly buy the stock on the cheap. Increased demand, in turn, boosts the listing price up to the level which is believed to reflect the true value of the IPO. This is deemed as a self-correcting characteristic of the markets.
A listing may be considered underpriced based on the gap between the initial offering price and the listing’s closing price on the first day of trade.
IPOs are complex processes, where one of the most challenging aspects is determining the offering price of the listing. This price has to take into account numerous factors that include real and projected cash flows of the listing.
If the set price is too high, the listing is considered overvalued, and lacking investor demand drives the price down until it reaches the level which fits the market by broad consensus.
Underpricing is also used as a conscious strategy during an IPO to boost demand for new and risky listings. An obvious mispricing may attract investors who may have been cautious at first, however, this can also backfire, as deliberately underpricing firms risk raising less funds.
