Why Are IPOs Underpriced?

Author: George Davis

IPO underpricing is the act of deliberately reducing the price of a particular share. Read this article to find out why IPOs are underpriced.

When a newly public company offers its shares for the first time in the market, these are termed Initial Public Offerings or IPOS. IPOs are sometimes risky for investors because the newly public company does not have sufficient financial proofs to back up its corporate position. Sometimes, these companies have a tough time in the stock market. Regardless of what future awaits an IPO, they are sometimes underpriced by underwriters. This intentional act of reducing the price of a particular IPO has baffled amateur investors for a long time, and we are here to tell you why IPOs are underpriced. So keep reading this article to learn more.

Reasons For Underpricing IPOs

According to Professor Ritter, over the last 50 years, IPOs have been underpriced by more than 16%. This translates t more than $125 billion left by companies on the table in terms of investment generation over the past 20 years. What’s surprising is that IPO underpricing is not an unintentional blunder. A beginner investor might not know the reasons behind IPO underpricing. Here are a few of these reasons that one should know.

1. Winner Curse

When a company launches its shares for the first time in the market, its share value is determined by underwriters. These underwriters evaluate a company’s financial performance and determine its worth, which is suitable for the issuing company and investors in the market. However, sometimes, unsophisticated investors fail to properly evaluate market trends and end up investing more than they should in IPOs. Therefore, to prevent retail investors (unsophisticated investors) from losing their interest in IPOs, underwriters deliberately underprice IPOs.

2. Market Feedback

Market feedback is a major reason for underpricing IPOs. It influences the initial share price of a company to the extent that it has to be launched at a lower rate. Moreover, market feedback relates to the demand and supply forces. For instance, if a company has less demand among investors, its initial share price will be lower because no one will be interested in buying at a high price.

3. The Bandwagon Effect

Most IPOs are underpriced to trigger the bandwagon effect. It’s a condition where unsophisticated investors follow sophisticated investors. Therefore, to create artificial demand, IPOs are underpriced. When a company launches its initial shares at a lower price, sophisticated investors whole-heartedly invest, reeling in unsophisticated investors as well. This creates a massive pool of investments for the issuing company and benefits both investors and the newly public company.

4. Help The Issuing Company Stay Afloat

IPOs are underpriced to help the newly public stay afloat and generate maximum investment as per their demand in the market. For instance, a company might evaluate its share price higher than what an underwriter has determined. However, underwriters know the demand for the newly public company in the stock market. Therefore, they deliberately lower the price to create interest among investors and help the newly public company stay afloat.

Ending Note

IPO underpricing is often a topic of debate among researchers and investors. Some deem it as beneficial for the newly public company. In contrast, others believe that it undercuts potential investment generation for the issuing company. Regardless of how IPO underpricing is perceived, one thing is for sure, reducing the price of a particular stock increases its demand.

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