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*Data are from Securities Data Co., with corrections by the authors. All sales have been converted into dollars of January 2000 purchasing power, using the Consumer Price Index. Sales are for the last 12 months prior to going public. There are 6,086 IPOs, after excluding IPOs with an offer price of less than $5.00 per share, unit offerings, REITs, ADRs, closed-end funds, and those with missing sales. The average first-day return is 19.0 percent. Sales are measured in millions. Source: Tim Loughran and Jay R. Ritter "Why Has IPO Underpricing Increased Over Time?" (University of Florida Working Paper, October 2001, as updated by the authors)

*Data are from Securities Data Co., with corrections by the authors. All sales have been converted into dollars of January 2000 purchasing power, using the Consumer Price Index. Sales are for the last 12 months prior to going public. There are 6,086 IPOs, after excluding IPOs with an offer price of less than $5.00 per share, unit offerings, REITs, ADRs, closed-end funds, and those with missing sales. The average first-day return is 19.0 percent. Sales are measured in millions. Source: Tim Loughran and Jay R. Ritter "Why Has IPO Underpricing Increased Over Time?" (University of Florida Working Paper, October 2001, as updated by the authors)

obscure the fact that much of the apparent underpricing is attributable to the smaller, more highly speculative issues. This point is illustrated in Table 16.3, which shows the extent of underpricing for 6,086 firms over the period from 1980 through 2000. Here, the firms are grouped based on their total sales in the 12 months prior to the IPO.

As illustrated in Table 16.3, the underpricing tends to be concentrated in the firms with little to no sales in the previous year. These firms tend to be young firms, and such young firms can be very risky investments. Arguably, they must be significantly under-priced, on average, just to attract investors, and this is one explanation for the under-pricing phenomenon.

The second caveat is that relatively few IPO buyers will actually get the initial high average returns observed in IPOs, and many will actually lose money. Although it is true that, on average, IPOs have positive initial returns, a significant fraction of them have price drops. Furthermore, when the price is too low, the issue is often "oversubscribed." This means investors will not be able to buy all of the shares they want, and the underwriters will allocate the shares among investors.

The average investor will find it difficult to get shares in a "successful" offering (one in which the price increases) because there will not be enough shares to go around. On the other hand, an investor blindly submitting orders for IPOs tends to get more shares in issues that go down in price.

To illustrate, consider this tale of two investors. Smith knows very accurately what the Bonanza Corporation is worth when its shares are offered. She is confident that the shares are underpriced. Jones knows only that prices usually rise one month after an IPO. Armed with this information, Jones decides to buy 1,000 shares of every IPO. Does he actually earn an abnormally high return on the initial offering?

The answer is no, and at least one reason is Smith. Knowing about the Bonanza Corporation, Smith invests all her money in its IPO. When the issue is oversubscribed, the underwriters have to somehow allocate the shares between Smith and Jones. The net result is that when an issue is underpriced, Jones doesn't get to buy as much of it as he wanted.

Smith also knows that the Blue Sky Corporation IPO is overpriced. In this case, she avoids its IPO altogether, and Jones ends up with a full 1,000 shares. To summarize this

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tale, Jones gets fewer shares when more knowledgeable investors swarm to buy an un-derpriced issue and gets all he wants when the smart money avoids the issue.

This is an example of a "winner's curse," and it is thought to be another reason why IPOs have such a large average return. When the average investor "wins" and gets the entire allocation, it may be because those who knew better avoided the issue. The only way underwriters can counteract the winner's curse and attract the average investor is to underprice new issues (on average) so that the average investor still makes a profit.

Another reason for underpricing is that the underpricing is a kind of insurance for the investment banks. Conceivably, an investment bank could be sued successfully by angry customers if it consistently overpriced securities. Underpricing guarantees that, at least on average, customers will come out ahead.

A final reason for underpricing is that before the offer price is established, investment banks talk to big institutional investors to gauge the level of interest in the stock and to gather opinions about a suitable price. Underpricing is a way that the bank can reward these investors for truthfully revealing what they think the stock is worth and the number of shares they would like to buy.

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