Basics referring to IPO-Undperpricing

Basics

Definitions & Differentiations

Underpricing is the difference between the issue price of a new share and the first trading price on the secondary market.

The scientific literature distinguish between the ex-ante underpricing and the ex-post underpricing. While the ex-ante underpricing is the difference between the expected price on the secondary market and the issue price, the ex-post underpricing means the difference between the realized first trading price and the issue price.

Synonyms for the notion "underpricing" are for example overpricing, initial return, raw return, excess return, Zeichnungsrendite or Emissionsrendite. But these notions could not be used equivalent, because of a different implied message. "Underpricing", for instance, implies the assumption of an informatically inefficient primary market, while "overpricing" implies the assumption of an informatically inefficient secondary market. The wording "initial return" or "raw return" means a price difference only regardless of an alternative investment. This is considered with the notion "excess return" which express that the return of the IPO is higher than the return of an comparable investment. Comparing different empirical studies with each other, it is necessary to take care of the respective message or implication of the wording.

Initial Public Offerings (IPOs) are the first offer of shares to the public. The emphasis is i) on shares, ii) on an offer to the wide public (otherwise it would be a private placement) and iii) on the first time that shares would be offered. If there are shares already in circulation, there is a market price for the shares, too - and it would be a seasonal equity offering (SEO) in contrast to an initial public offering (IPO).

Analytical Methods

Referring to the above mentioned definition, the extent of the IPO-Underpricing could be measured as the (diskreet) difference between the first trading price and the issue price:

IR_i = P_i,t - E_i

IR_i means the initial return (IR) of the share (i); P_i,t is the trading price (P) of the share (i) at its first trading day on the secondary market and E_i is the issue price (E) of the share (i). Strictly speaking, it is necessary to take in fact the first trading price on the first exchange trading to analyze the price effects of initial public offerings. But the empirical practice is often inaccurate. For instance, Saunders/Lim (1990) or Lee/Taylor/Walter (1996) use the closing price on the first trading day, Uhlir (1989) takes the "Kassakurs" (i.e. the official market clearing price) and Carter/Manaster (1990) refer to the closing bid price two weeks after the offering.

To make the initial return of a share comparable to another one it is customary to quote the initial return in relation to the issue price of the share (and multiply with 100 to get a proportional return).

This measure considers the price difference only and allows no statement about the fact, it the issue was "too cheap" or "too expensive" - since there is no standard of comparison. This would be an alternative investment, because an investor, sub-scribing to an IPO, has the possibility of an alternative investment instead. In comparison to this alternative investment only it is possible to value the extent of underpricing - if the IPO was underpriced or overpriced. This is the reason why the initial return of the share (IR_i) is usually adjusted by the return of an alternative investment to measure the extent of underpricing.

UP_i = IR_i - M

This notion is the market-adjusted underpricing because the initial return is adjusted by the return of "the market".

(M) means the price of the used market portfolio; (t) is the first trading price of the share (i) and (t,0) is the the price of the market portfolio on day "0". For this day "0" it is customary to take the day before the first trading day; strictly speaking one has to take the price of the market portfolio at the end (or the conclusion) of the subscribing period of the share (i).

Regarding this formula it is evident, that the selection of the market portfolio is of high importance for the empirical determination of the extent of IPO-Underpricing. Should the extent of the initial return be considered in comparison to a riskless investment or should the initial return be considered in comparison to an alternative investment which implies the same risk as the IPO? Aiming at the first, the underpricing is c.p. higher as if aiming at the second (a positive initial return provided). If the market portfolio should be an alternative investment bearing nearly the same risks a wide share index could be use to quote the extent of a market adjusted underpricing. This one is the customary approach. Using a market portfolio of the same risks of the IPO, the initial return would be risk-adjusted - but referring to Döhrmann (1989), the differences between the market-adjusted underpricing and the risk-adjusted underpricing are marginal only.

An alternative determination of the extent of IPO-Underpricing aiming not at the discreet difference of the first trading price and the issue price, but on a continual price adjustment between primary and secondary market. For instance, Wasserfallen/Wittleder (1994) or Ljungqvist (1997) use the following logarithm:

Even if both formula could be use to determine the extent of underpricing empirically the different implications of the price adjustment should be considered.

Issuing- and Placement Procedures

Furthermore, it is necessary to bring clarity to the terminology in the procedures for public offering of shares, because terms such as Emission methods, placement procedures, issuing procedures or placement forms are used differently. For an overview see for example Neus (1997), Hartmann-Wendel et al. (2000) or Ross/Westerfield/Jaffe (1999).

The main difference is as follows: if shares are offered to a wide audience in public, so it is a public offer or public issue. If the shares are offered only to a small circle of interests, it is a private placement or private issue. If the shares in a capital increase offered to new investors, it is a cash offer; if the shares are offered to the existing shareholders only about their rights, we call the off a rights issue.

The emission process describe the way of the issuer to the stock market: if the issuer request the admission of the shares to the stock exchange market by himself and if he takes the risk to sell the shares, it is spoken by a Selbstemission. Serves the issuer of a financial institution as an intermediary, however, it is a Fremdemission. In the latter case it is regulated in the context of the issue process, whether one or more banks are involved in the issue, whether the institutions assume (for the whole or for a part ony) the ownership, or if the financial intermediaries will sell the shares only. In any case the price for the takeover or the selling of the shares has to be defined by the two counterparties. In the emission nprocess called Fremdemission it can therefore be differentiated between committing a consortium, a consortium of warranty, a takeover consortium, a select consortium and a consortium unit (where a consortium can also very well consist of only one institution).

Unlike the issue procedures (emission process) the placement procedure describes the way of the shares to the investors. The shares may be offered to investors at a fixed price or in a bookbuilding process, which dominates in Germany. Latter is to be fitted with an over-allotment option (allotment) or an option to change the offer price, depending on the subscription success). Auction procedures are also possible, but not applied in Germany, although in France dominated this process.