Underpricing can be defined as the act of listing a given stock on the stock market at a price that is lower than the real value of the stock.
In most cases, a stock is said to be underpriced when it closes at a selling price that is higher than the IPO Price on the first day of trading.
However, it must be noted that underpricing techniques are mostly short-lived because eventually the market demand and supply restores to the given equilibrium.
In order to understand the concept of underpricing, it is important to understand the mechanics behind IPO, and the role of underwriters.
As a matter of fact, it can be seen that IPO refers to the instance where the company is allowed to publicly trade on the stock exchange.
Therefore, underwriters are hired to walk through this process, on basis of which the share price is decided on which the trading would begin on the day of the IPO.
Underwriters tend to determine the price of the offering based on a number of considerations that are both, quantitative and qualitative in nature.
Depending on a combination of these factors, they decide on the price based on which public would begin purchasing the stock of the particular company.
In the case where the stock price at day end is higher than the price that was set by the underwriters, it can be seen that the stock was referred to as underpriced.
On the contrary, if the stock price at day end was lower than the price set by underwriters for the IPO, the stock is said to be overpriced.
Reasons for IPO Underpricing:
An IPO is mostly underpriced on purpose in order to surge demand for the given stock. The main rationale in this regard is to encourage investors to invest in the given company.
This can be defined as the main rationale behind which stocks are underpriced deliberately. As a matter of fact, this is something that is purely fueled with the intent to gain traction on the day of the IPO, so that the company starts trading on the stock market on a high note.
This gives a much needed footing to the company on the stock market, and this subsequently helps companies to do better in terms of ensuring that they can make a place in the already cluttered stock market.
However, in certain cases, it can be seen that IPO underpricing, is not deliberate. In such instances underpricing mainly results because of an underestimation of demand of stocks on the first day of IPO.
This error is mainly committed as a result of an incorrect estimation on the part of underwriters.
This uncertainty on the part of investors acts as a blessing in disguise for the company, because the company is still able to make some traction on the actual day of the IPO.
However, if underwriters mistakenly overprice the stock price, it might backfire for the company, and might result in a flopped start at the market, which would not be very well-received by the shareholders.
In real terms, it is quite hard for underwriters to accurately predict the outcome of the IPO. However, there are different mechanisms in place that can help them to decide on the price at which the company would go forward with the IPO.
The accuracy of the analysis carried out by the underwriter comes forward on the day of the IPO. The lesser the spread between the starting and ending price of the stock on the day of the IPO, the greater the accuracy of the underwriter.
When it comes to underpricing, it can be seen that in the case where stocks are ridiculously underpriced to artificially instigate demand, it is likely to backfire for the company because of the reason that it will eventually result in shareholders finding out the actual worth of the share, and then this might result in a lower benchmark for the company.
Therefore, it can be concluded that IPO underpricing can be referred to as an instance where the stock price is lower than the actual real value of the stock. IPO underpricing can be deliberate or unintentional.
Regardless of the fact that it can be referred to as a legitimate technique to increase demand on the day of the IPO, falsely increasing demand might result in a bad reputation for the company.
In this regard, it is the utmost responsibility of the shareholder to ensure that they are able to avoid underpricing and begin stock trading on the day of the IPO with an accurate stock amount.