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Underpricing of IPOs

Suppose an IPO is a secondary issue, and the firm`s founders sell part of their holding to investors. Clearly, if the shares are sold for less than their true worth, the founderswill suffer an opportunity loss.

But what if the IPO is a primary issue that raises new cash for the company? Do the founders care whether the shares are sold for less than their market value? The following example illustrates that they do care.

Suppose Cosmos.com has 2 million shares outstanding and now offers a further 1 million shares to investors at $50. On the first day of trading the share price jumps to $80, so that the shares that the company sold for $50 million are now worth $80 million. The total market capitalization of the company is 3 million ГЧ $80 = $240 million.

The value of the founders` shares is equal to the total value of the company less the value of the shares that have been sold to the public ¤in other words, $240 Ј $80 = $160 million. The founders might justifiably rejoice at their good fortune. However, if the company had issued shares at a higher price, it would have needed to sell fewer shares to raise the $50 million that it needs, and the founders would have retained a larger share of the company. For example, suppose that the outside investors, who put up $50 million, received shares that were worth only $50 million. In that case the value of the founders` shares would be $240 Ј$50 = $190 million.

The effect of selling shares below their true value is to transfer $30 million of value from the founders to the investors who buy the new shares.

Unfortunately, underpricing does not mean that anyone can become wealthy by buying stock in IPOs. If an issue is underpriced, everybody will want to buy it and the underwriters will not have enough stock to go around. You are therefore likely to get only a small share of these hot issues. If it is overpriced, other investors are unlikely to want it and the underwriter will be only too delighted to sell it to you. This phenomenon is known as the winner`s curse.5 It implies that, unless you can spot which issues are underpriced, you are likely to receive a small proportion of the cheap issues and a large proportion of the expensive ones. Since the dice are loaded against uninformed investors, they will play the game only if there is substantial underpricing on average.

Underpricing of IPOs and Investor Returns

Suppose that an investor will earn an immediate 10 percent return on underpriced IPOs and lose 5 percent on overpriced IPOs. But because of high demand, you may get only half the shares you bid for when the issue is underpriced. Suppose you bid for $1,000 of shares in two issues, one overpriced and the other underpriced. You are awarded the full $1,000 of the overpriced issue, but only $500 worth of shares in the underpriced issue. The net gain on your two investments is (.10 ГЧ $500) Ј (.05 ГЧ $1,000) = 0. Your net profit is zero, despite the fact that on average, IPOs are underpriced. You have suffered the winner`s curse: you ¬win ­ a larger allotment of shares when they are overpriced.

The costs of a new issue are termed flotation costs. Underpricing is not the only flotation cost. In fact, when people talk about the cost of a new issue, they often think only of the direct costs of the issue. For example, preparation of the registration statement and prospectus involves management, legal counsel, and accountants, as well as underwriters and their advisers. There is also the underwriting spread. (Remember, underwriters make their profit by selling the issue at a higher price than they paid for it.)

Table 5.10 summarizes the costs of going public. The table includes the underwriting spread and administrative costs as well as the cost of underpricing, as measured by the initial return on the stock. For a small IPO of no more than $10 million, the underwriting spread and administrative costs are likely to absorb 15 to 20 percent of the proceeds from the issue. For the very largest IPOs, these direct costs may amount to only 5 percent of the proceeds.

Costs of an IPO

When the investment bank Goldman Sachs went public in 1999, the sale was partly a primary issue (the company sold new shares to raise cash) and partly a secondary one (two large existing shareholders cashed in some of their shares). The underwriters acquired a total of 69 million Goldman Sachs shares for $50.75 each and sold them to the public at an offering price of $53.6 The underwriters` spread was therefore $53 Ј $50.75 = $2.25. The firm and its shareholders also paid a total of $9.2 million in legal fees and other costs. By the end of the first day`s trading Goldman`s stock price had risen to $70. Here are the direct costs of the Goldman Sachs issue:

Direct Expenses

Underwriting spread 69 million ГЧ $2.25 = $155.25 million Other expenses 9.2 Total direct expenses $164.45 million

The total amount of money raised by the issue was 69 million ГЧ $53 = $3,657 million. Of this sum 4.5 percent was absorbed by direct expenses (that is, 164.45/3,657 = .045). In addition to these direct costs, there was underpricing. The market valued each share of Goldman Sachs at $70, so the cost of underpricing was 69 million ГЧ ($70 Ј $53) = $1,173 million, resulting in total costs of $164.45 + $1,173 = $1,337.45 million. Therefore, while the total market value of the issued shares was 69 million ГЧ $70 = $4,830 million, direct costs and the costs of underpricing absorbed nearly 28 percent of the market value of the shares.

5 The highest bidder in an auction is the participant who places the highest value on the auctioned object. Therefore, it is likely that the winning bidder has an overly optimistic assessment of true value. Winning the auction suggests that you have overpaid for the object ¤this is the winner`s curse. In the case of IPOs, your ability to ¬win ­ an allotment of shares may signal that the stock is overpriced.

FLOTATION COSTS The costs incurred when a firm issues new securities to the public.