Question

Explain why there is a tendency for IPOs to be underpriced.

Answer 1

IPOs are generally underpriced due to a variety of reasons. One reason is information asymmetry. The market consists of informed investors who have information about the stock & the IPO, and uninformed investors who do not have the required information. Informed investors will buy only those IPO shares which will give high returns whereas uninformed investors will buy indiscriminately and so, will suffer significant losses. This dissuades the uninformed investors from investing further in IPOs. However, since informed investors are a small percentage of the total investors, underwriters need uninformed investors to invest in order for the IPO to be successful. The direct consequence of this is to underprice the IPO so as to get most investors to buy the shares.

Another information related theory is informational revelation according to which, during the bookbuilding process, underwriters discount the stock to encourage aggressive bidding so as to get more bidders. As the number of bidders increases, more information about the bidding price helps in determining the IPO price.