In Practice The Underpricing of IPOs

Investment bankers generally underprice initial public offerings and are fairly open about the fact that they do. This gives rise to two questions. First, why don't the offering firms express more outrage about the value left on the table by the underpricing? Second, can investors take advantage of the underpricing by subscribing to dozens of initial public offerings? There are simple answers to both questions.

It is true that an underpriced initial public offering results in less proceeds going to the issuing firms. However, the loss of wealth is a function of how much of the equity of the firm is offered in the initial offering. If, as in the UPS offering, only 10% of the stock is being offered, we can see why many issuing firms go along with the underpricing. The favorable publicity associated with a strong opening day of trading may act as promotion for subsequent offerings that the firm plans to make in future months or even years.

It is not easy constructing an investment strategy that takes advantage of the IPO mispricing. If an investor applies for shares in a number of offerings, she is likely to get all the shares she requests in the offerings that are over priced and only a fraction of the shares she requests in the offerings that are underpriced (where there will be rationing because of excess demand). The resulting portfolio will be overweighted in overpriced public offerings and underweighted with the underpriced offerings, and the returns will not match up to those reported in IPO studies.

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