What is IPO underpricing

Most companies seek to attract additional investment for their development and growth. One popular way to accomplish this is through an initial public offering (IPO). An important aspect of the IPO process is determining the market value of the company and the share price before trading on the open market. One result can be an underpricing, a situation where the stock price is set lower than its actual value in the market. 

 

In this article, we look at the definition of IPO underpricing, why it occurs, and the benefits for different parties.

 

Definition of IPO underpricing

 

IPO underpricing means that the price of a company's shares at the time of its initial public offering is lower than the real value of the company or its growth potential. This can occur when an underwriter incorrectly determines the estimated value of a company. Underpricing can be either an accidental occurrence or a strategic decision to attract more investors.

 

What is a market valuation

 

Underwriters (investment banks and financial analysts) are responsible for determining the correct market price for a company before an IPO. After the valuation, they determine the optimal share price, taking into account the company's economic model and investor demand.

 

 

Underpricing can be caused by a lack of analysis or incorrect forecasting of the future value of the company, resulting in a shortfall in IPO proceeds. At the same time, overpricing can lead to low demand for the shares or even investors' rejection of the IPO.

 

The role of investors in IPOs

 

Investors also play an important role in the formation of IPO underpricing. If they do not properly analyze and consider the real value of the company, they may undervalue the stock and miss the opportunity to invest in a promising project. Some investors choose to participate in IPOs precisely because of underpricing, as they believe in the growth potential of the company and see the prospects for long-term investment.

 

Reasons for IPO underpricing

 

 

1) Attracting investors. Setting a lower share price can attract more interest from investors and allow a wider range of people to become shareholders in the company.

 

2) Risk reduction. Underpricing can also reduce risk for initial investors. If the stock price is lower at the IPO, the likelihood of a large drop in price after the IPO is also reduced. This can attract more conservative investors.

 

3) Increased liquidity. When shares are sold at a lower price, they become more accessible to the public, which can increase the liquidity of the stock in the market and encourage active trading.

 

4) Analysis and forecasting mistakes. Underwriters may incorrectly evaluate a company's market value and potential, which will affect the initial offering price of the stock.

 

Benefits and risks of IPO underpricing

 

 

Let's consider the main benefits of the undervaluation of the company in the IPO process.

 

- Greater investor interest. Underpricing can attract more investors and increase demand for the company's shares. This contributes to a more successful IPO and a higher share price after trading begins.

 

- Maintaining price stability. Establishing a lower share price can reduce the likelihood of sharp fluctuations during the initial trading phase, which contributes to price stability.

 

- Enhancing the company's reputation. A successful IPO can have a positive impact on a company's reputation and its attractiveness to potential investors and customers.

 

- Low entry barrier. Investors can purchase a company's stock at an undervalued price. If the investment bank has mispriced the value, the company's shares will subsequently rise and generate significant profits for investors.

 

Despite the benefits associated with IPO underpricing, this approach is also not without risks for both the company and investors.

 

- Loss of company capitalization. If the share price is set significantly lower than the market value of the company, the company's capitalization at the time of the IPO may decrease significantly. This can have a negative impact on the company's financial position, making it difficult for it to develop further and attract additional investment.

 

- Unsatisfied investors. In some cases, underpricing can cause dissatisfaction among investors who believe they have invested at an inflated value during the pre-IPO stages. This can affect investor confidence in the company and its management.

- Undermining market confidence. If the market learns of the underpricing, it can create suspicion and distrust in the company and its management. Investors may suspect that the company is trying to hide negative aspects of its operations, which could have negative consequences for the company's reputation and share price.

 

 

Brief conclusions

 

IPO underpricing is a strategic tool that can be used by companies to attract more investors and provide a more stable start to trading on the open market. This decision is not without risks, and companies should carefully analyze their value and growth potential before setting an IPO share price.

 

For investors, underpricing can be an opportunity to invest in promising companies at lower valuations. At the same time, it is important to remember that investing in shares is always risky, and investors should conduct their own analysis before making a decision to buy shares at the IPO stage.