Question

A company recently completed its Initial Public Offering (IPO). The shares were offered for sale at $40 each. On the first day of trading on the stock exchange the share price was $64.35. Why weren't the shares offered for sale at a higher price?

Answer 1

Answer:

The phenomenon of offering shares at IPO price lower than its its actual traded price or value is called underpricing of IPOs. The shares close on the opening day at prices that are higher than that at which they are offered in the IPO. Generally, underpricing is way of projecting value onto an IPO offering and keeping it attractive so that the image of the company's IPO offering after subscription is good for e.g. oversubscription

The outside investor does not know the true value of the shares and to compensate for the illiquidity and the pricing concerns of the investor and keep the IPO attractive to the investor, it is in the company's best interest to underprice them.

There is also a perception that IPO investors tend to apply the principle of 'folow the leader' while investing in IPOs. Since they do not know the true price or value of the shares at the time of investing in the IPO and are well aware that the promoters or insiders are mindful of the true value while taking up their holding, they tend to observe the promoter or insider behaviour at the time of IPO and after the stock goes live meaning that if the promoters or insiders mostly stay away from the IPO the IPO investors tend to follow suit and it would be best to underprice the IPO to keep its attarctiveness or if the promoters or insiders exit some or most of their invstments after the initial holding period they too can follow suit quickly. Thus the investor already knows and expects a profit from entering into IPOs and it is in everybody's best interests to underprice the issue.

Also the underwriter would like to ensure that the issue is a success and the shares are sold quickly, possibly oversubscribed thereby ensuring that they have some good demand after they go live so as to give the investors a benefit. Another reason is that the underwriters usuallly underprice IPOs so that they can atleast recover their initial investment once the stock starts trading.

In the given example, the company offered the shares for $40 each but on the first day of trade on the exchange the price was $64.35 enabling the investors and the underwriters to make a profit of $24.35 per share. The investors benefitted by getting appreciation on their investment and the underwriters could safely exit their investment on that day or maybe for a few days after opening.