Underpricing

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21 Aug, 2024

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Underpricing is an IPO (Initial Public Offering) strategy. The listing company issues shares below its real value. Companies sell underpriced stocks to attract more investors. In addition to fundraising, companies garner publicity.

For existing shareholders, this creates a perfect opportunity to exit. When a firm sells underpriced stocks, they reduce the cost of capital. On the flip side, it is a tedious procedure requiring multiple disclosures and compliance processes. LinkedIn, eBay, and Facebook are some popular examples of underpricing.

Underpricing Meaning

Underpricing is an IPO (Initial Public Offering) technique often applied by firms undergoing crises. The losing company keeps the offering price lower than its actual value.
Companies sell underpriced stocks for the following reasons: information asymmetry, legal court proceedings, and high demand result in underpricing.
If P_m is the stock price at the end of the first trading session, and P₀denotes the offering price of the stock, underprice percentage is expressed as follows:
Underpricing Cost = * 100

Underpricing In IPO Explained

Underpricing is an IPO technique where a company lists the stocks at a price below the original face value. As a result, the stock value increases from the IPO date to the first-day closing price. Thus, it acts as a fundraiser for the listing company.

From an investor's perspective, a low-priced asset can also be considered an oversold stock. Oversold stocks are undervalued. Therefore, an impending price bounce is highly likely. Conversely, when a particular market instrument is sold continuously, investors think the asset’s price has hit rock bottom—the asset becomes oversold.

This scenario can also signal the end of short-term declines and the beginning of an upward rally. Investors often look for oversold stocks to buy low and sell high. An overbought market is the polar opposite; the stock price is about to decline. Thus, when stocks are overpriced, they are called 'overbought.'

Before venturing further, let us define an IPO. An initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.

Now, IPO underpricing and IPO overpricing begin right at the listing. When companies are listed on a stock exchange, they can list at the original price or lower. So, the offering price depends on quantitative and qualitative factors. Cash flow figures mentioned in financial statements constitute the quantitative factors. So, to raise more capital, the management might price it low—so that more investors buy shares.

Theoretically, low-price IPOs hike by the end of the first day. The market corrects itself—the price is too low initially—very soon, the stock price reaches its actual worth.

Before World War I (1917 to 1945), 3.8% of IPOs were underpriced. In 1998, eBay released its IPO at $18, significantly below market value. eBay is an American e-commerce company. But, by the end of day one, eBay stock prices reached $47.38. By the 1900s, 9.15% of IPOs were priced below market value.

Underpricing Reasons

Let us look at the underpricing reasons.

#1 - Boosting Demand For A Stock

Primarily, corporations underprice IPOs to promote stock demand. Various IPOs are released every week, and the demand varies. Firms try to stand out; low-priced stocks could potentially achieve that objective.

#2 - Publicity

Sometimes, it is mere publicity. Low-price stocks can act like free advertisement—it is more likely to be covered by reporters and speculators. As a result, the price rises steeply on the first day.

#3 - Encouraging Stakeholders To Invest In The Company

Higher demand is possible only when investors are ready to take risks in the company. That is, investors should be motivated to take a risk. For example, investors take risks when they see the potential for exponential growth. Similarly, impressive cash flow, profits, revenue, and upcoming mergers allure investors.

#4 - Legal Issues

Sometimes, firms are forced to underprice their stocks — underlying crises. A legal issue is a common example.

Capital markets are volatile; irrespective of the details, rumors and market speculations have a huge impact. If a company undergoes court proceedings, its reputation can be tarnished (at least temporarily). But investors with a high-risk appetite will still buy if the stock is underpriced. For example, Facebook was sued in 2012; in response, Facebook underpriced its shares.

#5 - Unavailability Of IPO Information (Information Asymmetry)

Sometimes, investors lack knowledge about a particular company. Usually, informed buyers trade long-term. Uninformed investors bid randomly and lose money. But once the latter loses money, they stop bidding. Thus, corporations reduce uninformed investors' risk—by selling underpriced stocks. Conversely, both underpriced and overpriced stocks can distract target investors.

Formula

Let us look at the underpricing formula for a better understanding of the concept:

Underpricing Cost = * 100

P_m is the stock price at the end of the first trading session.
P₀denotes the offering price of the stock.

Examples

Let us look at an underpricing example to understand its calculation.

Example #1

The social media giant Facebook released its initial public offering (IPO) in 2004. The offering price was $38, and the closing price (day one) was $38.23.

Now let us apply the given values to the formula:

Underprice Percentage = * 100
Underprice Percentage = * 100
Underprice Percentage = *100
Underprice Percentage = 0.6%

Thus, the stock was underpriced by 0.6%.

Example #2

Now let us consider LinkedIn, a recruitment platform called. On May 19, 2011, the platform released an IPO at $45 per share. At the end of the first trading session, LinkedIn stocks closed at $94.25.

Let us apply the given values to the formula:

Underprice Percentage = * 100
Underprice Percentage = * 100
Underprice Percentage = * 100
Underprice Percentage = 109%

Thus, LinkedIn stocks were underpriced by 109%.

Advantages And Disadvantages

Now, let us look at the advantages and disadvantages.

Underprice selling is a well-known tactic—demand surges. But many more factors are at play in a volatile market—rumors, market speculation, and hype. So this is a perfect exit opportunity for existing shareholders.

But there is a flip side. First, there is an increase in transaction costs. Also, the company must meet various requirements and disclosures.

Advantages	Disadvantages
Acts as a fundraiser for the company.	Several requirements and disclosures have to be undertaken.
It creates the perfect exit opportunity for investors.	High transaction costs.
Additional capital and demand for their stocks.	Loss of control during decision-making.
Minimizes the capital cost.	Unusual pressure on management.

Frequently Asked Questions (FAQs)

Who benefits from IPO underpricing?

When companies underprice stocks, potential investors and underwriters benefit from it. When the offering price is low, investors get a discount. Likewise, the underwriter's job becomes easier—they can easily find investors eager to purchase.

What is the role of an underwriter in IPO underpricing?

Underwriters create a list of investors, along with their credentials. In addition, they set an offering price that can result in a price hike on day one itself.

What is the difference between overpricing and underpricing?

Although they sound similar, there is a significant difference. Underpriced stocks trade below their original value. In contrast, when companies sell an overpriced stock, the closing price at the end of the session is below the offering price of the IPO.