What Is IPO Underpricing, and Why Are IPOs Underpriced?

Author: James Clark

Everything that you should know about IPO underpricing

When an initial public offering or IPO is listed on the stock exchange market, its pricing will be set based on numerous factors. It may be that that the IPO is overpriced or underpriced. An underpriced IPO is when the price has been set below the stock's market actual value. Any new stock that closes its first day on the stock market below the IPO price set may be considered an underpriced IPO.

The good news is that underpricing doesn't last for long because, eventually, demand from investors drives the price up to its real market value and even beyond that.

Making Sense of Underpricing

Whenever a new stock is introduced for public trading on the stock market, an initial public offering or an IPO will be set for them. The reason for that is to raise capital for the growth of the company. The offering price determined is based on various factors. The main ones are the quantitative factors, which are the projected and real numbers of the company or its cash flow.

However, there are two things in play when an IPO is introduced in the market. The early investors and executives of the company want to set the share price as high as possible to reward themselves lavishly and raise capital. On the other hand, investment bankers advising them will want to keep share price down so that more shares are sold, resulting in them getting higher fees for trading from the company.

Pricing Factors for IPOs

It's not an exact science for IPO pricing, which means making sense of IPO underpricing won't be easy. The process involves comparables, facts, and projections:

• Quantitative factors, such as the financials of the company including its cash flow, earnings, expenses, and current sales. You can also factor in projected revenues.

• Any IPO price based on the price-to-earnings (P/E) should be compared with the company's competitors.

• The size of the future and current market for the service or product produced by the company.

• Another crucial thing is the company stock's marketability in the current market.

Why Are IPOs Underpriced?

In general, an IPO that has increased in pricing from its first day on the stock market had been underpriced. It doesn't matter if it was accidental or deliberate. The underwriters for the IPO may have underestimated demand from investors or may have underpriced shares deliberately to increase their demand. It's important to remember that overpricing an IPO is worse than underpricing it. Any stock that finishes below the IPO price on the first day of trading will be known as a failure.

An IPO may be underpriced if the company is uncertain about how the stock will be received in the market. In the worst scenario, the stock price will rise to the price investors think it is worth. In that instance, investors who are willing to take a risk will be rewarded, and the executives of the company will be happy.

That is infinitely better than the stock price of the company falling on the first day and the IPO being acknowledged by everyone as a failure.

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