Definition
Underpricing in finance refers to the practice of listing a company’s initial public offerings (IPOs) below their market value. This strategy is often used to attract more investors who can potentially drive up share prices, thus ensuring the success of the IPO. However, it can also mean that the issuing company may not raise as much capital as it could have with a higher initial price.
Key Takeaways
- Underpricing is a common practice in the Initial Public Offering (IPO) process where shares are sold at a price lower than the market value to attract investors and ensure the IPO is fully subscribed.
- Despite seemingly causing an immediate loss of revenue, underpricing can generate significant long-term benefits such as increased share price due to greater demand, improved reputation, and the potential for additional offerings.
- However, it’s worth noting underpricing can also have potential drawbacks if it’s excessively used, including dilution of existing stakes, signaling a lack of confidence in the firm’s prospects, and possibly misallocation of capital.
Importance
Underpricing is a crucial concept in finance, specifically in the realm of Initial Public Offerings (IPOs). It refers to the practice of listing a company’s initial share price below its actual market value. This method is important for several reasons.
Firstly, it generates greater interest among investors leading to high demand, ensuring all the shares are sold. Secondly, underpricing can trigger a first-day “pop” or surge in the share price, which not only provides publicity but also establishes credibility for the company.
Lastly, it serves as a form of insurance against the risk of the IPO “failing” i.e., shares not selling out due to potential overvaluation. Therefore, understanding underpricing is vital in making strategic decisions in investment banking and attracting investors during an IPO.
Explanation
Underpricing is typically leveraged in finance in the context of Initial Public Offerings (IPOs). The purpose of underpricing is principally strategic, designed to ensure the successful dispersal of a company’s shares when they are first made available to the public. Often, IPO underpricing is calculated and intentional, meant to stir investor interest and fuel demand.
This occurs when the shares being offered are priced at a level significantly lower than the established price in the secondary market. The underlying idea is that an underpriced IPO will be oversubscribed, ensuring the sell-off of all available stock, facilitating capital accumulation, and establishing a broad base of shareholders.
Underpricing also serves another key purpose: it works as an insurance mechanism against the uncertainties and risks associated with the first-time issuing of shares. There can be legal and reputational costs involved when an IPO fails; therefore, underpricing can act as a strategy to prevent such undesirable outcomes.
It has been observed that a carefully managed underpricing strategy can result in a ‘first-day pop’ or a substantial rise in share value once trading begins. This not only strengthens the company’s image but also generates positive publicity, instilling confidence among current and potential shareholders for future public offers or secondary issues.
Examples of Underpricing
In the realm of finance, underpricing often refers to the practice of selling an IPO (initial public offering) for a lesser price than its market value. This is done most of the time to attract investors. Here are three real-world examples:Facebook IPO: When Facebook listed on the stock market in 2012, they initially priced their shares at $
However, after a few months the price dropped to around half of its IPO value. Investors felt that the shares were underpriced because Facebook had yet to demonstrate a working mobile strategy and had not monetized its large customer base effectively.Royal Mail IPO: In 2013, the UK government faced criticism for underpricing the initial public offering of Royal Mail, which had been state-owned. Shares were sold for 330 pence but rose as high as 615 pence within a year, indicating that the shares had been significantly undervalued.
Alibaba IPO: In the biggest IPO in history, Alibaba Group Holding Limited was initially underpriced on the New York Stock Exchange inInitially priced at $68 per share, it finished the first day of trading at $
89, a 38% increase. The underpricing was deliberate to create a successful first day of trading, highlighting a positive future for the company.
FAQs on Underpricing
What is Underpricing?
Underpricing is a situation typically in an initial public offering (IPO), where the price at which shares are sold to the public is lower than the price it fetches in the open market. This often leads to a significant price ‘jump’ on the first day of trading.
Why do companies intentionally underprice their IPOs?
Though it might seem counter-intuitive, some companies intentionally underprice their IPOs to ensure that the IPO is oversubscribed. This creates a buzz in the market, drawing more attention and possibly more long-term investors.
What are the effects of Underpricing on the Financial Market?
Underpricing can lead to excessive demand and a sharp increase in price immediately after listing. While this can be beneficial for investors who got allotment in the IPO, it also increases the volatility and unpredictability of the market.
How can Investors benefit from Underpricing?
Investors that are allotted shares in the underpriced IPO, and sell their shares immediately after listing, stand to make a significant profit. This phenomenon is known as ‘flipping’. However, it should be noted that many IPO allocations are done on a lottery basis due to oversubscriptions, so not all investors applying for an underpriced IPO will receive shares.
Is Underpricing Fair on the Company undergoing an IPO?
Underpricing effectively means that the company may not receive as much funds from the IPO as they potentially could have. This could be considered a loss for the company. However, if the aim is to attract more interest and long-term investment in the company, underpricing could be seen as a strategic investment in marketing the company’s stock.
Related Entrepreneurship Terms
- Initial Public Offering (IPO)
- Market Value
- Book Building
- Issuer
- Securities Pricing
