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Initial public offering (IPO) underpricing is the tendency to price stock in a company slightly lower than its market value. This leaves money on the table and deprives the firm of earnings, but also ensures that shares sell out on the first day they are made available for purchase. Investors can profit from buying at the right time during an IPO, as they can flip their shares to take advantage of the initial jump in price that usually occurs when stock hits the market. Awareness of IPO underpricing is important for underwriters, as they need to develop an appropriate plan for marketing and selling shares.
In an IPO, a company makes shares available to the public for the first time through an underwriter. The underwriter works with the company to set a fair price and receives a block of shares at a discount to resell to investors, usually institutions with a relationship to the underwriter. These investors in turn can sell their stock to anyone. The company uses the IPO to raise capital for activities, and thus wants the highest price possible, but doesn't want to end up in a situation where the sale is undersubscribed, and the company is left with shares but no interested buyers.
The careful negotiations around price usually result in IPO underpricing. The underwriters recommend a reasonable price for the shares and may set it slightly on the low side to ensure a successful sale. Over the course of the trading day, the stock value may rise by 15% or more as investors buy and sell their shares. The company doesn't realize any of this additional money, as it only gets the value of the stocks sold initially. The IPO underpricing can leave the company wishing it had priced stock higher to capture more money from the sale.
Investors may track IPOs carefully so they can take advantage of IPO underpricing. An unusually low-priced IPO may create an opportunity for profit, as investors can swoop in, hold stock as the prices start to rise, and sell it right before they fall. There is often a great deal of interest in a new stock issue, and the value almost always rises, unless the shares are overpriced, a problem that can arise when underwriters overestimate interest in a new issue.
One way to resolve the pricing problem is to hold an auction at the time of an IPO. Auctions eliminate IPO underpricing and overpricing issues, as investors set the market value and decide how much to pay. They are not popular with underwriters, however, as the commission and potential profits are much lower.
@Soulfox -- there is a reason underwriters make such a profit off of IPOs and it is a good one -- they do assume some risk when they are involved in issuing one of those things. If the IPO is overpriced and doesn't sell as expected, then the SEC will investigate and they underwriter could be in trouble. So, yes, underwriters do err on the side of caution.
Also, keep in mind that the issuing company in your example wants $10 million. It gets its $10 million and that might not have been the case if the IPO was priced too high and didn't sell out as expected.
The way IPOs have been priced has been controversial for a long time. Let's say we have a company that wants to raise $10 million in capital through an IPO. As it turns out, the company can raise that by selling 1 million shares of stock for $10 apiece. The price is set at that point and the shares are issued.
In the United States, an IPO increases in value during a day of trading by 100 percent. In our scenario, then, the stock trades for $20 per share by the end of the day. Let's say that all sells are sold for that price by the time the market closes.
This is a simplistic scenario but it
points out the problems with IPO underpricing. In our scenario, the company gets its $10 million but an equal amount goes to underwriters and other financial intermediaries.
To many, that just seems somehow wrong and demands for reform have been made. A little profit for underwriters is fine, but this scenario seems to pad those profits to a ridiculous degree.