Underpricing
Candlefocus EditorIPOs, or the issuance of a company’s first public stocks, are often priced below their true worth to encourage a greater volume of investors to purchase the new shares. In some cases, a company seeks to maximize the volume of shares subscribed for in the public offering by underpricing the stock. Employing this strategy has several advantages. It can bring a higher level of public visibility and capital to a company, and the stock price usually increases sharply when it first enters the open market. This can create a degree of goodwill among investors, who may be enticed by the sharp gains to then purchase more shares of the stock in the future.
There are, however, potential drawbacks to underpricing an IPO as well. Companies risk missing out on potential profits as a result of underpricing their offering, and the underwriters of the IPO may also suffer losses due to the reduced profitability of the transaction. Furthermore, if the stock is overly underpriced, it may cause speculation among investors which may drive its price down greatly in the following trading session.
Underpricing may also occur unintentionally due to undervaluing the IPO’s true worth. In this case, the underwriters misjudge the market demand for the stock and consequently set the price of the IPO too low. This could mean that the firm loses out on potential profits, and that the investors also suffer due to the lower stock price.
However underpricing occurs, it is a potentially significant event in the life of a company. If done intentionally, it can bring increased attention and capital to the firm; if done unintentionally, it can mean lost profit opportunities. Either way, it is a strategy that should be examined carefully in order to ensure that it produces the desired results and does not lead to potential losses or other risks to the company.