Question

Why do some overpriced/overvalued IPO's under perform in the long run?

Answer 1

Ans: Creation of Hype during IPO by the underwriters -The first reason is that investors -- often goaded into believing by fancy theses put forth by underwriters or stockbrokers – believe that the firm they are investing in is the next great investing opportunity.That is, they’re willing to accept a high probability of below-average returns to have a long shot at an outsized return.This makes investing in so-called “high-growth” companies with shaky business models, stretched valuations or hazy future cash flow visibilities easy.

In the secondary market, prices are determined on the basis of buying and selling (as well as short-selling) that a exchange like NYSE is witnessing. The weights of optimistic and pessimistic views about the stock’s future prospects both reflect in its price and in many cases balance each other out to reflect more closely to its fundamental value and since the price of a stock that is about to be listed only reflects the level at which investors would buy , such issues tend to become over-priced initially and which shows up in the long-term performance as a under performing shares in the market.

Often, firms that come to the market have a shorter operating history than the average firm already listed on the market.The greater uncertainty arising from the fact that such firms are relatively younger making it difficult to forecast their future earnings leads to a greater divergence in opinion over its prospects. This often leads to a higher price than it would in case of companies with more predictable earnings.

“As the company develops an operating history, it becomes easier to forecast its future earnings and dividends. The divergence of opinion shrinks. This lowers the price relative to well-seasoned stocks given the same mean valuations by investors,” and these are the few cause of companies IPO with higher price perform poor under long run in the market.