Why do investment banks underpricing an ipo

Quantitative factors are considered first. Those are the numbers, real and projected, on cash flow. Nevertheless, there are two opposing goals at play. The company's executives and early investors want to price the shares as high as possible in order to raise the most capital and reward themselves most lavishly.

The investment bankers who are advising them may hope to keep the price low in order to sell as many shares as possible since higher volume means higher trading fees for them. The process mixes facts, projections, and comparables:. In theory, any IPO that increases in price on its first day of trading was underpriced, whether it was deliberate or accidental. The shares may have been deliberately underpriced to boost demand.

Or, the IPO underwriters may have underestimated investor demand. Overpricing is much worse than underpricing. A stock that closes its first day below its IPO price will be labeled a failure. An IPO can be underpriced if its sponsors are genuinely uncertain about the reception that the stock will receive. After all, in the worst case, the stock price will immediately climb to the price that investors consider that it's worth.

Investors willing 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 first 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.

Stock Markets. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content.

Create a personalised content profile. Measure ad performance. Select basic ads. The regulations related to securities issues in many countries make the investment bankers liable for any type of misinformation and the financial losses arising from the same.

Hence, if it is proven in court that the investors were sold an overpriced issue, the investment bankers could face a huge liability. Hence, they deliberately lower the valuation and keep a spread for themselves and underprice the shares. However, the fact remains that in order to protect themselves from the lawsuits, the underwriters do have an incentive to provide a lower valuation to the shares. Information Asymmetry: Another reason which has been mentioned by many studies is the fact that huge information asymmetry exists during an IPO.

When an IPO process is announced, the investors are buying into a relatively unknown commodity. The business of the company has been private until then, and hence their financial performance is also not disclosed to the public. The IPO process does make it mandatory to disclose financials for the past few years.

However, there is still a huge information asymmetry. This is the reason that the bidding shareholders always bid a lower price.

This is because they will bid on many IPOs on average. Some issues will turn out to be overpriced. Hence, to be conservative, investors bid a lower price on an IPO. The selling company is also aware of this issue. However, they do not seem to protest because once the IPO has been issued and found to be worthwhile, the investing community provides a better valuation to the subsequent public offerings.

Hence, it can be said that underpricing is a kind of premium that the company has to pay to induce the investors to bet their money on an unknown company.

Informed investors bid only on the offerings they think will gain superior returns. But with weak I. The losses are so great that the uninformed investors will eventually leave the I. The underwriters, however, need the uninformed investors to bid since informed investors do not exist in sufficient number.

To solve this problem, the underwriter reprices the I. The consequence is underpricing. This theory has found empirical support in papers that have found that when investment banks can allocate shares in greater measure to informed investors, the underpricing is reduced since the compensation needed to draw uninformed investors is lower. Underpricing has also been found to be lower when information about the issuer is more freely available so that uninformed investors are at less of a disadvantage.

Another informational-based theory for I. This theory centers on the book-building process, the mechanism by which an underwriter builds a book of potential investors and the prices and number of shares they are willing to purchase.

The book-building process is intended for the underwriter to assess demand and obtain information from potential buyers about what price buyers are willing to pay. In order to incentivize investors to disclose sufficient information about the price they believe is appropriate, underwriters allocate fewer shares to potential purchasers who bid low.

But underwriters still discount the stock to incentivize aggressive bidding and to ensure that the bids are not even lower since the more bids there are, the more information is revealed about the appropriate price for the stock.

Issuers accept this underpricing because it allows underwriters to better gauge a higher sale price. This theory too has found empirical support in the academic literature. A third strand of the informational asymmetry theory asserts that underpricing is associated with the weakness of the issuer. The underpricing is intended to compensate the purchasers for this weakness. This theory has found weak evidential support.

The investment bank conflict theory, the one Mr. Nocera supports, posits that investment banks arrange for underpricing as a way to benefit themselves and their other clients.

There is some mixed evidence to support this argument.