Underpricing
Underpricing is an event of listing an IPO at a rate below market value.
A way of spotting underpriced IPOs is by observing whether or not the new stock trades above the IPO price on the first day of trading. It is a temporary phenomenon, because the market has a tendency to correct the mispricing – as investors notice the underpricing, their demand drives up the price to the adequate level.
The purpose of an IPO is to help companies raise capital in exchange for ownership rights of the company. In order to estimate the value of the company that would be used as a reference point during an IPO, one needs to take into account a number of factors – both quantitative, such as cash flow, and qualitative, like brand name and future potential.
In this process there are two competing forces at play:
- Owners of the company seek higher valuation for that would enable them to raise more money for the company
- Investment bankers seek lower valuation in hopes that it would attract more initial buyers that would in turn result in more transaction fee gains for the bank
In this environment, underpricing can be both a deliberate tactic by the investment bankers or an accidental miscalculation.
