Underpricing

What Is Underpricing?

Underpricing is the practice of listing an initial public offering (IPO) at a price below its real value in the stock market. When a new stock closes its most memorable day of trading above the set IPO price, the stock is considered to have been underpriced.

Underpricing is brief because investor demand will drive the price upwards to its market value.

Understanding Underpricing

A initial public offering (IPO) is the presentation of a new stock for public trading on a stock exchange. Its purpose is to raise capital for the future growth of the company.

Determining the offering price requires a consideration of many factors. Quantitative factors are considered first. Those are the numbers, real and projected, on cash flow.

Nevertheless, there are two opposing objectives at play. The company's executives and early investors need to price the shares as high as possible to raise the most capital and reward themselves most richly. The investment bankers who are prompting them might hope to keep the price low to sell however many shares as could be allowed since higher volume means higher trading fees for them.

IPO Pricing Factors

IPO pricing is a long way from an exact science, so it is equally inexact to underprice an IPO. The process mixes realities, projections, and comparables:

• Quantitative factors considered include the company's financials including its current sales, expenses, earnings, and cash flow. Projected earnings likewise are factored in.
• An IPO price that reflects a price-to-earnings (P/E) multiple comparable to the company's industry peers is looked for.
• The size of the current and near-future market for the product or service that the company produces is considered.
• The marketability of the company's stock in the current economic environment additionally is pivotal.

Why Underprice?

In theory, any IPO that increases in price on its most memorable day of trading was underpriced, whether it was deliberate or accidental. The shares might have been deliberately underpriced to help demand. Or on the other hand, the IPO underwriters might have underestimated investor demand.

Overpricing is a lot of worse than underpricing. A stock that closes its most memorable day below its IPO price will be labeled a failure.

An IPO can be underpriced assuming its sponsors are genuinely uncertain about the reception that the stock will receive. After all, in the most pessimistic scenario, the stock price will immediately move to the price that investors consider that it's worth. Investors ready to take a risk on a new issue are rewarded. The company's executives are pleased.

That is considerably better than the company's stock price falling on its most memorable day and its IPO being blasted as a failure.

Whether it was underpriced or not, once the IPO debuts the company becomes a publicly traded entity owned by its shareholders. Shareholder demand will determine the stock's value in the open market proceeding.

Highlights

• It could be underpriced accidentally because its underwriters underestimated the demand in the market for this company's stock.
• An IPO might be underpriced deliberately to help demand and encourage investors to take a risk on a new company.
• Regardless, the IPO is considered underpriced by the difference between its first-day closing price and its set IPO price.