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Underpricing is a term that is usually applied when an initial product offering is extended at a rate or price that is considered to be less than market value. This will mean that the offer price at the time of the IPO will be different from the price of the first trade on the offering. Generally, this is a temporary situation that quickly corrects itself based on the economic principles of supply and demand.
There are a couple of reasons why a company may choose to engage in underpricing. One key reason is to take advantage of human nature. Many people enjoy getting a bargain. This is certainly true of people who choose to make financial investments. By initially pricing the stock at less that the market value that experts believe the stock is worth, the investor senses a great deal that will earn a return in a very short period of time. Thus, the company offers the stock for a limited time beginning at the point of original issue at a reduced price and motivates people to get in on a good thing at the ground level.
Second, underpricing not only attracts investors who will quickly move to secure a limited number of shares. The strategy also can help to boost the public profile of the company. This can help to attract more investors who miss the first wave of the IPO but choose to invest based on the early performance of the stock. At the same time, the buzz created by the underpricing also raises the awareness of the business community regarding the company and the goods and services offered by the corporation. This can lead to profitable business to business relationships, new clients, and an increased bottom line that ultimately will further enhance the value of the stock.
While underpricing often works very well, it is not an approach that should be utilized by every company at the time of the initial public offering. Depending on the short and long-term goals of the company, the type of products offered, and the expectations of performance, underpricing may actually hurt the prospects of the company rather than enhance them. For this reason, owners and partners associated with the firm should consider all options before deciding to lead with a first trade price on an initial offering.
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