Before going in details, presenting the explanations advanced for the short run IPO
anomaly, it is logical to begin by a definition of this notion of “underpricing” to understand
this short run phenomenon:
Early writers that have been interested in IPO market, notably Stoll and Curley (1970), Logue
(1973), Reilly (1973) and Ibbotson (1975), are the first who documented that when companies
go public, the price of shares they sell tends to jump substantially on the first day of trading.
The first day closing price is systematically higher than the issue price at which the public
offering was introduced in the market. Consequently, IPOs exhibit positive first day returns
on average with no exception to the industry to which the IPO belongs, to the country and to
the period and date of going public. That has been the first and the most important
observation in the IPO market.
From an issuer’s point of view, this phenomenon is usually called underpricing, as it describes
the additional amount of money which could have been raised by the issuer if the offer price
had been set at an appropriate level. Indeed, if the issuer had been set a higher offer price for
his offering shares, the issue price could have been easily accepted by the investors interested
in purchasing the IPO shares, since a run up is observed on the first day of trading. The
trading begins by the offer price which is less than the apparent maximum price achievable at
the end of the first trading day. In a way it is an amount of money left on the IPO table from
the issuers’ point of view. Therefore, underpricing is an expression used to describe the issuer
point of view, as he thinks that he has not correctly valued the IPO shares, he underpriced the
real value of the shares of his company.
Underpricing is estimated as the percentage difference between the price at which the shares
subsequently trade in the market (the first day closing price) and the price at which the IPO
shares were sold to investors (the offer price or the issue price) and at which the offering was
introduced. Underpricing is suggesting that firms which go public leave considerable amounts
of money on the table. The amount of money left on the table is defined as the difference
between the closing price on the first day and the offer price, multiplied by the number of
shares sold. In the words of Jay Ritter, this is the first-day profit received by investors who
were allocated shares at the offer price. It represents a wealth transfer from the shareholders
of the issuing firm to these investors. So, underpricing is a loss, a cost for the issuers that they
want to minimize and a profit for the first investors that purchase and acquire the IPO shares.