Why IPOs Are Underpriced?

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 A report on-

Why IPOs are Underpriced?

Course Name: Financial Markets and Institutions

Course No.: FIN-403

Prepared for-

S. M. Zahidur Rahman
Assistant Professor
Business Administration Discipline
Khulna University

Prepared by-

Abdur Rakib Akon ID-070305

S. M. Mazharul Islam ID-070351

3rd year, 2nd Term

BBA Program
Business Administration Discipline
Khulna Universtiy

Date of Submission: January 13, 2010

Business Administration Discipline

Khulna University
Decent 07 (Khulna university, BBA)
INDEX

Topic Page No.

Introduction 01

An Overview of Bangladesh Capital 02

Market

Literature Review 02

Findings from Major Stock Exchange 03

Findings from Asian Stock Exchange 03

Reasons for Underpricing 04

Research Methodology 04

New Issues of Industry 06

Level of Underpricing/Overpricing 07

IPO Underpricing on Yearly Basis 08

IPO Underpricing on Industry Basis 08

IPO Overpricing on Industry Basis 09

Our Observation 09

Conclusion 11

References 12

Appendix

(Note: Insert page no according to INDEX)

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INTRODUCTION

An initial public stock offering (IPO) referred to simply as an "offering" or "flotation," is when
a company issues common stock or shares to the public for the first time. They are often issued
by smaller, younger companies seeking capital to expand, but can also be done by large
privately-owned companies looking to become publicly traded. In an IPO the issuer may obtain
the assistance of an underwriting firm, which helps it determine what type of security to issue
(common or preferred), best offering price and time to bring it to market. An IPO can be a risky
investment. For the individual investor, it is tough to predict what the stock or shares will do on
its initial day of trading and in the near future since there is often little historical data with which
to analyze the company. Also, most IPOs are of companies going through a transitory growth
period, and they are therefore subject to additional uncertainty regarding their future value. The
underpricing of initial public offerings (IPO) has been well documented in different markets.
While Issuers always try to maximize their issue proceeds, the underpricing of IPOs has
constituted a serious anomaly in the literature of financial economics. Many financial economists
have developed different models to explain the underpricing of IPOs. Some of the models
explained it as consequences of deliberate underpricing by issuers or their agents. In general,
smaller issues are observed to be underpriced more than large issues (Ritter, 1984, Ritter, 1991,
Levis, 1990) Historically, IPOs both globally and in the United States have been underpriced.
The effect of "initial underpricing" an IPO is to generate additional interest in the stock when it
first becomes publicly traded. Through flipping, this can lead to significant gains for investors
who have been allocated shares of the IPO at the offering price. However, underpricing an IPO
results in "money left on the table"—lost capital that could have been raised for the company had
the stock been offered at a higher price. Therefore, taking many factors into consideration when
pricing an IPO, issuers attempt to reach an offering price that is low enough to stimulate interest
in the stock, but high enough to raise an adequate amount of capital for the company. The
process of determining an optimal price usually involves the underwriters ("syndicate")
arranging share purchase commitments from leading institutional investors. A company that is
planning an IPO appoints lead managers to help it decide on an appropriate price at which the
shares should be issued. There are two ways in which the price of an IPO can be determined:
either the company, with the help of its lead managers, fixes a price or the price is arrived at
through the process of bookbuilding. IPO underpricing is a regular phenomenon in the stock
market. Underpricing of IPO’s is the indication of contradiction to stability and the efficiency of
the market. Basically underpricing of IPO’s occurs depending on choosing of the time period to
launch the share. The underpricing varies from one issue to another. In Bangladeshi stock market

Decent 07 (Khulna university, BBA)

existence of higher degree of underpricing is found. Still it is Degree of underpricing varies from
one issue to another. The purpose of this study is to find out the price behavior of the Dhaka
Stock Exchange. This study will give idea about the extent of IPO underpricing/overpricing and
its determinants. There are some unique features in each country and these features might affect
underpricing. Institutional differences in pricing and allocation of shares play an important role
to give an idea about underpricing. There is a unique characteristic in Bangladesh capital market
that is here IPOs are allowed for dual listing. It is found that major portion of IPOs that are listed
with CSE is also listed at DSE. So it will be interesting one to find out the causes and
determinants of under pricing in case of IPOs.

BANGLADESH CAPITAL MARKET-AN OVERVIEW

Bangladesh capital market is quite small compared to the size of its economy. Bangladesh
market has only stock market, though there should be both stock and debt market. The stock
market is considerably small in size. Among over 40,000 small and medium companies only 310
have become listed till April 30, 2007.Though the governments tried to introduce the enterprises
into public limited company, but they seemed to be very less interested. In spite of having good
advancement in industrialization still the money of entrepreneurs are in the bank not in the
capital market. Bangladesh has two Stock Exchanges, Dhaka Stock Exchange (DSE) and
Chittagong Stock Exchange (CSE). All exchanges are self-regulated, private sector entities
which must have their operating rules approved by the Securities and Exchange Commission

(SEC).As of 31 December 2006 the total issued capital of all listed securities of Dhaka Stock
Exchange was TK 71,745 million where as in Chittagong Stock Exchange the total issued capital
was TK 68,554.72 million.

LITERATURE REVIEW

Initial public offerings (IPOs) are nowdays talk of the day in the world economy. Research
showed that IPOs have the tendency of providing abnormal returns to investors who purchased
them at the initial offering. The underpricing of initial public offerings (IPOs) is an indirect cost
of going public that is borne by the issuing firm. Its magnitude varies across IPOs with different
issue characteristics, allocation mechanisms, underwriter reputations, and general financial
market conditions.Usually in an efficient market the price of the newly issued stock will

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immediately be adjusted on the basis of available relevant information. There are two reasons for
a firm to introduce itself in the stock market. Number 1 cause can be the diversification of the
portfolios for the firm. The number 2 Cause is the lackage of alternative source of funds for their
investment project. Some other reasons to introduce IPO can be overcoming borrowing
constraints, greater bargaining power with banks, liquidity and portfolio diversification,
monitoring investor recognition, change of controls and windows of opportunity. The price of
IPOs may be susceptible to the existence of significant conditional price trends in the short-run
for several reasons: first, there exists a growing body of literature noting that market reaction to
the signals or news announcements issued by seasoned firms is not completed immediately.
Instead, market prices adjust slowly to such news or signals, with trends extending over several
months. There is always some uncertainty about the real value because of the lacking of public
information at the time of introducing. In a real haphazard situation in stock market measuring
the value of a newly issued IPO is extremely difficult. Consequently, the initial return on an IPO
provides the first public indication that the market consideration about IPO really varies. In
addition, under the signaling theories the initial market price gives a signal of the standard of the
introduced IPO. Second, because of fragmented market for IPOs, the first market price fails to
reflect all the available information. The issue size of IPOs is normally small and the
underwriters, those are usually issued to some regular customer, who used to be potential
investor. Initial trading in the aftermarket serves to disseminate information about the value of
IPOs to other investors. While initial upward price movement of underpriced IPOs spreads
favorable information, the available supply of shares is restricted because underwriters typically
discourage initial subscribers from selling their allotments in the aftermarket. Investors who were
unable to obtain their full subscriptions at the offering may seek to buy shares in the aftermarket,
resulting in a sequence of daily positive returns. Issuing firms can attempt to reduce underpricing
by engaging reputable underwriters and auditors, having frequent disclosures, waiting until they
possess desirable characteristics, and/or using the auction method if they are of high quality.

Evidence from major Stock Exchanges

A research was made using the data from the period 1972 to 1975. The finding showed that
usually new issues ensured comparatively higher return in the first week of the issue, but results
are mixed when the consideration is one year.

Evidence from Asian Stock Exchanges

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In Bangladesh context studies were made about the underpricing and initial returns of IPOs, IPO
flipping, market efficiency and effect of capital structures on the returns. The IPOs of DSE was
largely underpriced (285.21%).
Thus, this has showed that the cross-sectional variations of abnormal returns can be
explained by some institutional characteristics, such as-

• The percentage of equity retained by the state and legal entities

• The time lag between the offering and listing an the stage of development of the province
from which the IPO firm comes,
• Which is proxied by the number of stock investors in the province.

Reasons for underpricing

Much of the theoretical research on IPOs has focused on explaining IPO

underpricing. Possible reasons for underpricing include-
• self-interested
• investment bankers,
• the “winner’s curse”, lawsuit avoidance,
• signaling,
• market incompleteness,
• bookbuilding and informational cascades.
Evidence suggests also that in some countries IPO underpricing may be due to the regulatory
environment, or because the allocation of IPO shares can be used as a bribe. Some theoretical
work suggests that the underpricing of IPOs is associated with asymmetric information and
investors' concerns that the decision to issue equity is an attempt to expropriate wealth from
outsiders. Empirical studies have found evidence that the underpricing for IPOs of financial
institutions is related to proxies for asymmetric information. From astudy conducted empirical
tests on the relationship between regulations and underpricing it is found that the length of time
from price setting to listing date is negatively related to underpricing.

OUR OBSERVATION

IPOs are underpriced to signal issue quality, mitigate adverse selection problems, reward
investors for truthfully revealing information, lessen underwriters’ potential legal liabilities,
allow underwriters to curry favor with their clients, promote ownership dispersion for liquidity

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and control, and attract media attention/publicity. IPO underpricing, is one of the most
perplexing puzzles in finance. It is observed in almost every financial market in the world and
across all procedures of share allocation. IPOs are, on average, underpriced by 18–20% in the
United States. During the hot issue period, underpricing was much higher, as many of the IPO
firms did not have strong financials or growth potential and simply rode the wave to go public. In
countries where regulations and restrictions are imposed in the IPO market, underpricing is
higher as well. The first-day closing price represents what the investors are willing to pay for the
firm’s shares. If the offer price is lower than the first-day closing price, the IPO is said to be
underpriced and money is left on the table for new investors. Since existing shareholders settle
for a lower offer price/proceeds than what they could have got, money left on the table represents
the wealth transfer from existing shareholders to new shareholders. Although most IPOs are
underpriced, the level of underpricing varies across IPOs with different issue characteristics,
allocation mechanisms, underwriter reputation, and general financial market conditions. For
example, the level of underpricing is reduced for larger IPOs, those underwritten by prestigious
investment banks, firms with a longer operating history or more experienced insiders on the
board, and those which intend to use the proceeds to repay debt. On the other hand, technology
firms, firms backed by venture capital, firms with negative earnings prior to the IPO, or firms
that went public during a bull market experience greater underpricing. Some studies suggest that
investment banks underprice IPOs to protect their reputation. When new issues are priced lower
than they should be, investment bankers reduce their legal liability by lowering the chance of
price declines. There is also evidence that greater underpricing leads to more aftermarket trading
volume, which increases the revenue of investment bankers when they subsequently become the
market-makers for these IPO firms. Investment bankers also benefit from underpricing because it
allows them to curry favor with their clients in exchange for their loyalty and continued business.
These explanations do not make it clear why issuing firms approve underpricing as it only
benefits the investment banks. Underpricing comes at the expense of the original owners and
venture capitalists of the issuing firm. However, these insiders typically do not strongly oppose
or even attempt to avoid it, because they generally do not sell their shares until about six months
later, after the lockup period expires. To them, underpricing creates excitement that could help
create sustainable interest in the firm’s shares, thus keeping demand strong until they are ready to
sell. Additionally, insiders are so contented with their new-found wealth that they do not mind
leaving some money on the table for new investors. Underpricing is simply viewed as an
inevitable cost of going public.

RESEARCH METHODOLOGY

This study will examine new companies, which were listed on the DSE for the period 1995-
2009. All the data used in this study will be secondary data gathered from: DSE, CSE and SEC
websites, and some other reports of renowned scholars. The population of this study includes

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companies in the DSE & CSE. This study includes IPO issuers in various sectors. Main aim of
the study was to find out the reason behind the initial high returns of those new issues. We found
that the underpricing for IPOs is related to proxies for asymmetric information. Some issues such
as Offer size, age of the firm, and the volatility of the post-offer return are related with IPO
underpricing. Recently conducted study found that the length of time from price setting to listing
date is negatively related to underpricing. Considering the size of the firm and the type of
industry related to underpricing following hypothesis is proposed:

• IPOs are underpriced.

• Positive relationship between age of firms and degree of Underpricing.
• The larger the size of offer, the lower the underpricing.
• There is a relationship between timing of offer and degree of underpricing.
• The larger the size of firm, the lower the underpricing.
• There is difference between IPOs in different industry and degree of underpricing.

The underpricing/overpricing was measured by the rules given below:

Rj,t = [Pj, t - Pj, 0]/Pj,0

Where
Rj, t = return of stock j in the period t,
Pj, t =the price of stock j at the period t,
Pj,0 =the offer price of stock j.

Returns was measured with Pj,0 using the opening price to determine the return for investors
who were unable to buy the stock when it was offered but bought it on the opening day. Method
of finding out factors that significantly affect underpricing is described below:
UND = α0 +α1AOF + α2SOF+ α3SOFF +α4 TIME+α5TYPE + ε
Where
UND = Underpricing/Overpricing,
AOF = Age of the firm,
SOF = Size of the firm,
SOFF = Size of the offer,
TIME = Timing of the offer, and
TYPE =Type of industry

Age of the firm was computed from the date of incorporation to the date of IPO. The company
size was measured by using the net assets of the company in the year of IPO. Timing of offer
was measured as the time taken from the date of listing to the offer date.

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 RESULT

Table 5: New Issues on an Industry-to-Industry Basis

sector 2004 2005 2006 2007 2008 Total

Financial 02 11 08 03 05 29
Manufacturing 00 00 01 00 00 01
Food and 00 00 00 00 00 00
Allied
Products

00 01 04 01 00 06
Pharmaceutical

and Chemicals

Tannery and 00 00 00 00 00 00
textiles

Services and 00 01 03 01 00 05
misc

Total 02 13 16 05 05 41

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The sample data is consisted of companies that are listed into DSE between the periods of 2004
to 2008. Table presents the sample profile of listed companies in the sample period at DSE. The
highest number of companies was from the financial sector. There was a slack enlistment in 2007
and 2008 due to emergency and some anti-graft drive.

LEVEL OF UNDERPRICING/OVERPRICING

Table 6: Overall Levels of IPO Underpricing and Overpricing

condition Number of Mean Level Maximum Minimum Standard

companies of Deviation

Underpricing

underpricing 36 186.45 3215 1.54 392.43

overpricing 03 18.98 63.85 2.00 21.31

Similar 02 00 00 00 00
pricing

total 41 148.90 3215 1.54 376.98

This section presents the level of underpricing and overpricing in the Dhaka Stock Exchange.
overall level of underpricing at the Dhaka Stock Exchange was 186.45% with a standard
deviation of 392.43 , There were 36 IPOs(87.80%) underpriced and only 03 (7.31%) were
Overpriced.

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IPO UNDERPRICING ON YEARLY BASIS

Table 7: IPO Underpricing on a Yearly Basis

year Number of Mean Level of Standard Maximum Minimum

Companies Underpricing Deviation

2004 02 300.1250 141.24458 400.00 300.1250

2005 12 260.2986 214.49269 761.50 35.75

2006 09 154.3404 120.58589 353.50 13.50

2007 04 174.0579 125.11938 466.17 24.00

2008 05 70.1763 43.61641 124.50 5.70

The highest degree of underpricing was registered in the year 2004 (300.13%with a standard
deviation of 141.22%). However there were only two companies listed in this year.

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IPO UNDERPRICING ON INDUSTRY BASIS

Table 8: IPO Underpricing on an Industry Basis

Industry Number of Mean Level Standard Maximum Minimum

Companies of Deviation

Underpricing

Financial 27 93.80 125.90 675 .76

Manufacturing 01 332.60 548.02 1231.87 4.2

Food and Allied 00 00 00 00 00

products

Pharmaceutical 06 223.90 347.70 789.78 5.56

and Chemicals

Tannery and 00 00 00 00 00
Textiles

Services and 04 64.98 45.876 234.90 27

Misc.

Total 41 118.89 147.66 1231.87 .76

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The highest level of underpricing recorded at the Dhaka Stock Exchange was the manufacturing
sector (1231.87% with a standard deviation of548.02). There were only one companies
underpriced from this sector.

IPO OVERPRICING ON INDUSTRY BASIS

The highest level of overpricing recorded in the pharmaceuticals Sector (62.30% with a standard
deviation of 213.90). There were three Companies overpriced in this sector during sample
period.

CONCLUSION

When companies go public, the equity they sell in an initial public offering tends to be
Underpriced, resulting in a substantial price jump on the first day of trading. The empirical
evidence supports the view that degree of underpricing in the Bangladesh capital market is high
in comparison to that of others. At the same time, the enormous variation in the extent of
underpricing over time raises doubt in some people’s mind whether information-based
explanations on their own can account for the huge amounts of money left on the hand rather
than investing in IPO.. In order to remedy this tendency, some code of conduct and financial
penalty can be implemented. Now a days IPO’s are offered in the market though electronic
transfer system, which is rated by credit rating companies. This will certainly tame down the
unusual underpricing tendency. Security and exchange commission has the highest
responsibilities regarding this matter.

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REFERENCES

1. http://www.wbiconpro.com/1.Aminul.pdf

2. http://www.qfinance.com/contentFiles/QF02/g1xtn5q6/12/2/the-cost-of-going-public-
why-ipos-are-typically-underpriced.pdf

3. http://www.cgu.edu/PDFFiles/Drucker/JFE_Forthcoming.pdf

4. http://library.tu.ac.th/acc-pdf/mif/mif-13.pdf

5. http://www.isb.edu/caf/docs/RaviJagannathan.pdf

6. http://www.claremontmckenna.edu/econ/papers/2005-03.pdf

7. www.dsebd.org

8. www.stockbangladesh.com

9. dse.com.bd

10. http://www.dsebd.org/latest_share_price_scroll_l.php

11. www.csebd.com

12. www.cse.com.bd

13. www.wikipedia.com

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