Question

Define what is meant by the statement that “the typical IPO is underpriced.” Provide THREE possible explanations for IPO underpricing.

Answer 1

1. If in IPO all shares are not subscribed by the public then the underwriters would have to keep the shares. Underwriters wouldn't want to take such risk to have large number of stocks unsold if perceived to be pricey. So underpricing the stocks ensures all stocks would be subscribed reducing risk for underwriters. As underwriters are responsible for pricing, they generally keep price low relatively to ensure it is subscribed. Thus, underwriters may encourage underpricing.

2. If shares are not fully subscribed, which will be the case if it is oversubscribed, then market perceives that the stock is risky or its fundamentals are not strong. A good share is almost always oversubscribed. Thus, even the company wouldn't want to be priced so highly as to reduce subscription levels to the point where it is undersubscribed, sending a negative signal to the Market.

3. For boosting demand and encouraging people to take risk on a new company IPOs are underpriced. Also to attract uninformed investors it becomes essential to underprice. Else, no one would be interested in buying shares. Also public demand is not certain. Underpricing would help in selling all shares.