IPO undercutting is pricing a stock slightly below market value to ensure a successful sale, but it can leave money on the table for the company. Investors can profit by buying at the right time, and underwriters need to develop an appropriate plan for trading and selling shares. Auctions can solve pricing problems but are not popular with subscribers.
Initial public offering (IPO) undercutting is the tendency to price the stock in a company slightly below its market value. This leaves money on the table and deprives the company of profit, but also ensures that the shares are sold out the first day they become available for purchase. Investors can profit by buying at the right time during an IPO, as they can flip their shares to take advantage of the initial jump in price that usually occurs when the stock hits the market. Knowledge of IPO undercutting is important to underwriters as they need to develop an appropriate plan for trading and selling shares.
In an initial public offering, a company makes shares available to the public for the first time through an underwriter. The underwriter works with the company to establish a fair price and receives a block of shares at a discount to resell to investors, typically institutions with a relationship with the underwriter. These investors in turn can sell their shares to anyone. The company uses the IPO to raise capital for activities and therefore wants the highest possible price, but it doesn’t want to end up in a situation where the sale is underwritten, and the company is left with shares but no interested buyers.
Careful price negotiations generally result in low IPO prices. Underwriters recommend a reasonable price for the shares and may set it slightly on the low side to ensure a successful sale. Over the course of the trading day, the value of shares can increase by 15% or more as investors buy and sell their shares. The company does not realize any of this additional money, since it only gets the value of the shares initially sold. Undervaluing from the initial public offering can leave the company wishing it had traded higher in order to capture more money from the sale.
Investors can track IPOs carefully so they can take advantage of IPO undervaluation. An unusually low IPO can create an opportunity for profit, as investors can move in, hold shares as prices begin to rise, and sell just before they fall. There is often great interest in a new share issue, and the value almost always rises unless the shares are overvalued, a problem that can arise when underwriters overestimate interest in a new issue.
One way to solve the pricing problem is to hold an auction at the time of an IPO. Auctions eliminate the underpricing and overpricing issues of IPOs as investors set the market value and decide how much to pay. However, they are not popular with subscribers, since the commission and potential earnings are much lower.
Smart Asset.
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