Study On The Effects Of Ipo Underpricing Finance Essay - Free Essay Example

Underpricing is the difference between the issue price of a new share and the first trading price on the secondary market. It is a worldwide phenomenon of almost each capital market that has been well documented in different markets. Numerous empirical studies find evidence that the first trading price is about 20 per cent higher than the issue price of the shares on average.This phenomenon has been experienced in almost every country with a stock market, although the degree of underpricing varies from country to country. The study of Loughran, Ritter and Rydqvist (1994) confirmed this IPO underpricing phenomenon in 25 countries, with higher IPO underpricing in developing than in developed markets. For example, the level of underpricing in the US was 15.3% (for 10,626 IPOs during 1960-92), in France was 4.2% (for 187 IPOs during 1983-92) and in Malaysia was 80.3% (for 132 IPOs during 1980-91). Lowry and Schwert (2000) find that the number of IPOs and the average initial returns are highly auto correlated and that both price update and the initial return are predictable based on publicly available information. They suggest that these differences are highly significant and provide strong evidence favoring the asymmetric information theory. Su and Fleisher (1999) analyze Chinese IPOs during the period of 1985-1987 and find that the level of underpricing for a share is 948.6%. Arosio et al (2000) analyze a survey of Internet stock IPOs, listed on the Euros secondary Stock Exchanges and find an in itial average return equal to 76.43%. They document that this huge underpricing is strongly related to the information gathered during book-building activity in the pre-selling period, which drives the revision of the prospectus price range and signals the IPO quality to uninformed investors. Chowdhry and Sherman (1996) document that the average first-day return varies systematically with the mechanism used to price and distribute IPOs. Ritter (2001) points out that fixed price offerings are more underpriced than offerings built by the book. Ljungqvist et al (2000) analyze 2105 IPOs in 61 non-US markets during the period 1992-1999 and document that the direct costs of book-building are twice as large as direct costs for fixed-price offers, but the book-building leads to substantially less underpricing. On the other hand, Derrien and Womack (2000) analyze the French IPOs market during the period 1992-1998 and find that auctions IPOs are less underpriced (9.7%) than book-building I POs (16.9%). For Taiwan, Liaw et al (2000) find that the degree of underpricing for price-fixed IPOs is 34.6% and 7.8% for auctions IPOs. Kutsuna and Smith (2000) also point out that in Japan, auctions IPOs are less underpriced (11.50%) than book-building IPOs (70.81%). Several explanations are possible for these countrys differences. Institutional differences probably play an important role, as underwriters follow different price setting and allocation strategies across country. On the following table we can see a detailed list of different studies about this phenomenon in financial markets worldwide and the different levels of underpricing of the IPOs accordingly to country and period of time. Country Authors Sample size Period Underpricing Germany Ljungqvist 170 1978-92 10,9% Australia Lee, Taylor Walter 266 1976-89 11,9% Austria Aussenegg 67 1964-96 6,5% Brazil Aggarwal, Leal Hernandez 62 1980-90 78.5% Canada Jog 383 1971-948 43% Chilli Aggarwal, Leal Hernandez 19 1982-90 16,3% China Su and Fleisher 308 1987-95 948,5% United States Ritter 13,308 1960-96 15,8% Finland Keloharju 85 1984-92 9,6% France Derrien Womack 264 1992-98 13,2% Hong Kong McGuinness 334 1980-96 15,9% Italy Giudici Paleari 135 1985-98 23,9% Japan Hebner Hiraki 472 1970-91 32,5% Malaysia Paudyal, Saadouni Briston 95 1984-95 61,8% Mexico Aggarwal, Leal Hernandez 37 1987-90 33,0% New Zealand Firth 149 1979-87 25,8% Holland Eijgenhuijsen Buijs 72 1982-91 7,2% United Kingdom Levis 2,133 1959-90 12,0% Singapore Lee, Taylor Walter 128 1973-92 31,4% Suede Rydqvist 251 1980-94 34,1% Efficient Market Hypothesis (EMH) Formulated by Eugene Fama in 1970, the Efficient Market Hypothesis that suggests that at any given time price fully reflect all available information on a particular stock or market is highly controversial and often disputed theory concerning the market efficiency by the economists. Thus, accordingly to the EMH, no investor has an advantage in predicting a return on a stock price since no one has access to information not already available. A market is said to be efficient if prices adjust quickly and, on average, without bias, to new information. As a result, the current prices of securities reflect all available information at any given point in time. Consequently, there is no reason to believe that prices are too high or too low. For Fama, there are three primary conditions that must be true to validate the EMH: 1. There are no transaction costs in trading securities. 2. All available information is available to all market participants at no cost. 3. All actors on th e market fully agree on what the implications of current and future information has on the price of a security. The conditions above is a picture of the perfectly efficient market, but the capital markets worldwide today are so far away from the perfect market, which does not necessarily means that the securities traded on these market are wrongly priced. According to the kind of information available, we can distinguish three version of the EMH: The Weak Form The weak form is the degrees of efficient market hypothesis (EMH) that claims all past prices of a stock are reflected in todays stock price. Therefore, future prices cannot be predicted by analyzing price from the past. It is named weak form because prices are arguably the most public as well as the most easily available pieces of information. Thus, one should not be able to profit from using something that everybody else knows. However, while EMH predicts that all price movement in the absence of change in fun damental information is random many studies have shown a marked tendency for the stock markets to trend over time periods of weeks or longer. The Semi-Strong Form The Semi-Strong form suggest that only information that is not publicly available can benefit investors seeking to earn abnormal returns on investments; the current price fully incorporates all publicly available information (past prices, data reported in financial statements, earnings and dividend announcements, announced merger plans, the financial situation of companys competitors, expectations regarding macroeconomic factors as well as non-financial factors). Semi-strong efficiency of markets requires the existence of market analysts who are not only financial economists able to comprehend implications of vast financial information, but also macroeconomists, experts adept at understanding processes in product and input markets. The Strong Form In strong-form efficiency, share prices reflect all informati on, public and private, and no one can earn excess returns. Not even insider information could give an investor the advantage. This degree of market efficiency implies that profits exceeding normal returns cannot be made, regardless of the amount of research or information investors have access to. The main difference between the semi-strong and strong efficiency hypothesis is that in the latter case, nobody should be able to systematically generate profits even if trading on information not publicly known at the time. The rationale for strong-form market efficiency is that the market anticipates in unbiased manner future developments and therefore the stock price may have incorporated the information and evaluated in a much more objective and informative way than the insiders. However, the January effect, the weekend effect, the month effect, small firm effect and the IPO underpricing effect constitute some of the anomalies documented about the EMH. Some past events have feed arguments against the EMH; a look on the historical returns of some investment funds show that some investors, like Warren Buffet or Peter Lynch, have been beating the market year after year. The IPO underpricing anomaly shows that new shares appear to be issued with a discount on its true value. Ibbotson (1975) was the first to test this kind of anomaly, and after applying some test, he found that new issues were underpriced 16.8% in average. Later, this anomaly was also tested by Ibbotson and Jaffe (1975). This anomaly therefore constitutes the subject of this thesis; considering the Cyprus Stock Exchange. Valuation The valuation and pricing of an initial public offer is a difficult and contentious issue. Trying to gauge market sentiment and setting a price that does not spell disaster in terms of the desired objectives is a real challenge. IPOs will be valued using a variety of method. Studying 49 IPOs conducted in Brussels between 1993 and 2001, finance professors Marc Deloof and Wouter De Maeseneire and researcher Koen Inghelbrecht isolated the valuation models used to set initial share prices and determined which provide the most realistic snapshot of market prices. Underwriters in the study never employed just one valuation method. In all 49 of the IPOs studied, the underwriters used discounted free cash flow (DFCF); in 24, they also used the dividend discount model (DDM), and in 40, they added price-to-earnings, price-to-cash flow, or other multiples valuation methods. However, Kim and Ritter (1999) find only a modest ability to explain the pricing of IPOs using accounting multiple s, even when using earnings forecasts. Purnanandam and Swaminathan (2001) construct a measure of intrinsic value based on industry matched Price/Sales and Price/Ebitda from comparable publicly traded firms (comps) for a sample of over 2,000 IPOs from 1980-1997. They find that, when offer prices are used, IPO firms are priced about 50% above comparables, which is an enormous difference. The Capital Asset Pricing Model In 1964 William F. Sharpe published a theory that explains the relationship that exists between the risk and return expected. This model, the Capital Asset Pricing Model is applied to price securities that present risk. According to Investopedia, the CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). In other words, it is an equilibrium model that explains how assets are priced in an efficient market, taking into consideration their risk, providing a benchmark for evaluating if securities are at a fair price given their level of risk, serving also as a tool for pricing new securities not traded before. The CAPM is one of the most used investment model to determine risk and return despite it is only valid unde r special set of assumptions; some being unrealistic, met or not valid (investor: are rational and risk-averse, are price takers; that means that it is impossible for them to influence prices, but they can lend and borrow unlimited amounts without interest rate risk, trade with no costs, perfect Competitive Markets). There are three steps to build an intuition for the CAPM model: We first consider an asset that has no volatility, no risk; with returns that do not vary with the market. As a result, the asset has a beta equal to zero, producing an expected return equal to the risk-free rate. Then, an asset with beta one should be considered. It has to move in lock-step with the market. The result of this perfect correlation with the market is a return on the asset equal to the return of the market. At the end, we think about an asset with a beta greater than one that experiences greater swings in periodic returns than the market. As a result, we would expect that this asse t will give returns superior to those of the market, as compensation for this extra risk. Investopedia present the following formula: Where: is the expected excess return on the capital asset is the risk-free rate of interest such as interest arising from government bonds (the beta coefficient) is the sensitivity of the expected excess asset returns to the expected excess market returns is the expected excess return of the market is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return). Using the Capital Asset Pricing Model  under the assumptions above it is possible to calculate the expected return of a stock. However, there are some concerns about the overall efficacy of the CAPM. Several academic researches in recent years have made the CAPM true predictive power questionable. When realized returns are compared to what the CAPM would have expected, the model is often incorrect. Many researchers believe that other risk factors have significant impact on expected returns in the market. Moreover, to correctly test how well the CAPM prices securities we must assume that the market is efficient, which means that we are testing two hypothesis simultaneously, which raise a doubt if the inconsistency is due to a bad asset-pricing asset model or due to a inefficient market. Furthermore, Richard Roll (1977) has claimed that the model cannot be tested since the market portfolio cannot be observed because it consists of all risky assets. He has said that the only way to test it is using a market index, what would be able to serve as a market portfolio, but the problem is that a market index does not include all risky assets. The Arbitrage Pricing Theory The Arbitrage Pricing Theory developed by Stephen Ross (1976) and based on the idea that identical assets in different market should be priced identically is often viewed as an alternative to the Capital Asset Pricing Model since the APT  has  more flexible assumption requirements. Tradetaxfree.com define the APT as an asset pricing  model  based on the idea  that an assets returns can be predicted using  the relationship between that same asset and many common risk factors;   it predicts a relationship between the returns of a  portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables. Whereas the CAPM formula requires the markets expected return, APT uses the risky assets expected return and the risk premium of  a number of  macro-economic factors. Arbitrageurs use the APT  model to profit by taking advantage of mispriced securities. A mispri ced security will have a price that differs from the theoretical price predicted by the model. The economic factors in the model are not specified in the original APT model, but Roll and Ross (1980) have identified five factors that affect the price, as follow: changes in the expected inflation, unanticipated changes in inflation, unanticipated changes in industrial production, unanticipated changes in the default-risk premium and unanticipated changes in the term structure of interest rates. Since the anticipated factors are already reflected in the price of an asset, the unanticipated factors cause a change in the price of the asset. For example, if we consider a bond with a fixed coupon interest, which current price is the net present value of expected interest and principal payments, discounted at some rate that reflects the time value of the money, the uncertainty of these future cash flows and the expected inflation rate. If there is an unanticipated increase in inflatio n, what will happen to the price of the bond? It will go down, since the discount rate increases as inflation decreases. This mechanism is similar to all other economic factors in the determination of the price of an asset along the time. The APT Model is not without drawbacks. The sensitivities must be estimated, since the model is based on the sensitivities of expected returns to unanticipated changes in the factors; the best we can do is to look at historical relationships (like in the CAPM). Also, some financial researchers argue that a single factor, namely the market portfolio, does just as good a job in explaining security returns as the more complex multiple factor approach of the APT Model. Why Do Firms Go Public? A companys main motivation for going public is to raise funds. For a better understanding of the IPOs underpricing phenomenon, is important also to understand why firms go public. Basically there are two theories related to IPO underpricing that cover why do firm go public: Life Cycle Theories and Market Timing Theories. Life Cycle Theories According to the Life Cycle Theories, as a firm grows and become sufficiently large, it will reach the optimal conditions to go public. Some authors related this theory to the IPO underpricing. For Zingales (1995), for a potential acquirer, public targets are easier to spot than private targets. Entrepreneurs can facilitate the acquisition of their company for a higher value after the IPO. By going public, entrepreneurs can get a higher value for their company if it is acquired by diversified investors than if the company was privately owned and sold in an outright sale. For Chemmanur and Fulghieri (1999), Early in its lifecycle a fi rm will be private. As it grows and faces profitable investment opportunities, the costs of going public are worth incurring. It does so to allow for greater dispersion of ownership. Pre-IPO angel investors and VCs hold undiversified portfolios and, therefore, are not willing to pay as high a price as diversified public-market investors. The same subject is approached under another perspective by Maksimovic and Pichler (2001), providing another explanation. They point out that by going public, the owners of the company attract a market competition, generating an increased demand for the shares of the company, and consequently, increasing the value price of the company. By trading at a price under fair value for the company, it keeps competition at a low level. Market Timing Theories Lucas and McDonald (1990) while discussing about asymmetric information model state that firms postpone (seasoned) equity issue if they know they are currently undervalued. If there are common m isevaluations, aggregate issue volume will increase following bull markets. Welch and Ritter (2002) propose a semi-rational theory without asymmetric information to explain increased IPO volume following bull markets: Entrepreneurs sense of value derives more from their operations perspective and underlying business fundamentals than from public markets. Ljungqvist and Wilhelm (2002) also supported and confirmed it by measuring the underpricing of firms going public during the dot-com bubble. Explanations literature 3. Asymmetric Information Models 3.1 The Winners Curse The winners curse, developed by Rocks (1986) is probably the best-known asymmetric information model. The winners curse provides the explanation for the information asymmetry between the investors. In this model, some investors are assumed to be better informed about the shares real value than underwriter, issuing firm and other investors. Uninformed investors are the losers, as they do not know which issues will be underpriced and so they are allocated large fraction of overpriced shares while investors that possess information call only for good priced IPOs. Beatty and Ritter (1986), Barry and Jennings (1993) support this hypothesis by providing evidence from U.S. market. Rock assumes that all IPOs must be underpriced in expectation considering that the demand of informed investors is not enough to fill all shares on offer even at good price. He also assumes that firms going public benefit from underpricing. Underpricing ensure that uninformed investor will continue to partici pate and bring capital to the IPO market. However, underpricing is clearly costly to certain firm that going public; it results in a lost capital that could have been raised in the case if the offering price had been set higher. In wikipedia page about IPO, we have the example of theglobe.com IPO during the IPO mania of the late 90s internet era. Underwritten by Bear Stearns on November 13, 1998 the stock had been priced at $9 per share, and famously jumped 1000% at the opening of trading all the way up to $97, before deflating and closing at $63 after large sell offs from institutions flipping the stock . Although the company rise about $30 million from the offering it is estimated that with the level of demand for the offering and the volume of trading that took place the company might have left upwards of $200 million on the table. 3.2 Information Revelation Theories (or informational cascade (to check and choose)) Rocks (1986) winners curse has lead to book-building; method that give underwriters wide discretion over allocations. It refers to underwriters extracting indications of interest from investors. The formations collected are then used for set the offer price. Following the Rock assumption that some investors are better informed than the company and other investors, Benveniste and Spindt (1989), Benveniste and Wilhelm (1990), and Spatt and Srivastava (1991) demonstrate that underwriters now elicit information before setting the price of the share for company doing an IPO. They state that book-building can be such a technique under certain conditions. However, the underwriters have to manage to find a way to lead investors to reveal the truth information. Underwriters do not allocate shares or only few to any investor who bid conservatively after they have collected investors indications of interest. By doing so, they reduce the incentive for informed investor to misrepresent po sitive information. On the other hand, investors who reveal favorable information are rewarded with important allocations of shares. More investors bids, more the offer price goes up. However, to make sure to gather the truth from investor, the shares allocated need to be underpriced. Even though the shares are underpriced, the firm has benefit to take on these deals. By repeating this process, underwriters and investors achieve a reduced cost of information acquisition. Repetition also allows underwriters to bundle offerings across time. Some extension goes with the Benveniste and Spindt (1989) theory. Benveniste and Wilhelm (1990) examine the interaction of their theory with Rocks (1986) winners curse. They argued that if book-building succeeds in extracting the informed investors private information, the informational asymmetry among investors will be reduced. This, in turn, reduces the winners curse and thus the level of underpricing required to ensure the uninformed inves tors break even. Busaba et al(2001) demonstrate the level of required underpricing can be reduced by the underwriters in the case where reliable withdraw option is proposed on if the offering. Ljungqvist (2006) states, in the Benveniste and Spindt framework, investors incur no cost in becoming informed. If information production is costly, underwriters need to decide how much information production to induce. Sherman and Titman (2002) explore this question in a setting where more information increases the accuracy of price discovery, resulting in a trade-off between the benefit of greater pricing accuracy and the cost of more information production. In short, with book-building, a preliminary offer price range is set, and then underwriters and issuers go on a road show to market the company to prospective investors. This road show helps underwriters to gauge demand as they record indications of interest from potential investors. If there is strong demand, the underwriter wi ll offer a higher price. The information gathering perspective of book-building is certainly useful, but the theory also suggests that the information provided by one incremental investor is not very valuable when the investment banker can canvas hundreds of potential investors. Thus, it is not obvious that this framework is capable of explaining average underpricing of more than a few percent. 3.3 Principal-Agent Models Loughran and Ritter (2004) insist on the inconvenient of the book-building theories by examining the possibility of agency problems to occur between the underwriters and the issuing company. Early models linking agency conflict and initial public offering are more on the way that the informational advantage that underwriters have over issuing companies might allow them to not use the maximum of their capacity to promote and distribute the stock. Baron and Holmstrà ¶m (1980) and Baron (1982) build a model that focus on the banks benefit from underpricing. In that model, the issuer firms assign the pricing decision to the bank in order to generate efficient use of the banks superior information concerning the demand. Biais et al (2002) combine the agency cost setting of Baron (1982) with Benveniste and Spindts (1989) assumption that some investors hold pricing-relevant information worth extracting before the offer price is set. In such a setting, the investment banker could collu de with the informed investors, to the potential detriment of the issuing company. Biais et al (2002) derive an optimal IPO mechanism that maximizes the issuers proceeds. In this mechanism, the IPO price is set higher the fewer shares are allocated to (uninformed) retail investors. Allocating more to institutional investors when their private signals are positive (i.e. when the IPO price should be set higher) is consistent with Benveniste and Spindts information. 3.4 Signaling of Firm Quality Theory Allen and Faulhaber (1989), Welch (1989) et al (1989) consider underpricing of IPOs as a tool used by firms to signal their quality. Investors through underpricing become aware of the true value of firm so the market expects less money on the table in the future subscriptions. To distinguish themselves from the pool of low-quality issuers, high-quality issuers may attempt to signal their quality. In these models, better quality issuers deliberately sell their shares at a lower price than the market believes they are worth, which deters lower quality issuers from imitating. With some patience, these issuers can recoup their upfront sacrifice post-IPO, either in future issuing activity, favorable market responses to future dividend announcements, or analyst coverage. signaling models have in common that high quality firms demonstrate that they are high quality by throwing money away. One way to do this is to leave money on the table in the IPO. However, on theoretical grounds, it is unclear why underpricing is a more efficient signal than, say, committing to spend money on charitable donations or advertising. The evidence in favor of these signaling theories is, at best, mixed: there is evidence of substantial post-issuing market activity by IPO firms (Welch (1989)), and it is clear that some issuers approach the market with an intention to conduct future equity issues. However, there is reason to believe that any price appreciation would induce entrepreneurs to return to the market for more funding. Jegadeesh, Weinstein, and Welch (1993) find that returns after the first day are just as effective in inducing future issuing activity as the first-day returns are. Michaely and Shaw (1994) outright reject signaling: in a simultaneous equation model, they find no evidence of either a higher propensity to return to the market for a seasoned offering or of a higher propensity to pay dividends for IPOs that were more underpriced. Still, aside from the pers istence of the signaling explanation on the street, its most appealing feature is that some issuers voluntarily desire to leave money on the table to create a good taste in investors mouths. As such, it is relatively compatible with higher levels of IPO underpricing. If investors are more informed than the issuer, for example about the general market demand for shares, then the issuer faces a placement problem. The issuer does not know the price the market is willing to bear. In other words, an issuer faces an unknown demand for its stock. A number of theories model a specific demand curve. One can simply assume that all investors are equally informed, and thus purchase shares only if their price is below their common assessment. Observed (successful) IPOs thus are necessarily underpriced. There are, however, some overpriced IPOs going public, which would not be predicted because all investors are assumed to know that these would be overpriced. A more realistic assumption is that investors are differentially informed. Pricing too high might induce investors and issuers to fear a winners curse (Rock (1986)) or a negative cascade (Welch (1992)). 4. Institutional Explanations 4.1 Legal Liability Tinic (1988) states that IPOs are underpriced by firm in order to decrease the probability of lawsuit by investors. Indication of a legal liability can create negative impression for an IPO and can cause the failure of the issue. This idea goes back to Logue (1973) and Ibbotson (1975) whose believe companies intentionally sell their stock under the price to reduce the chance of lawsuits by future shareholders frustrated by the performance of their shares after the introduction. This theory concerns mostly the united state because differently to the IPOs underpricing, strict liability laws are not a worldwide phenomenon. Research have shown that law suit is not significant in some country. Tinic (1988), Hughes and Thakor (1992), and Hensler (1995) argue that intentional underpricing may act like insurance against securities litigation. Lawsuits are costly to the firms in term of legal fees, diversion of management time and potential damage to their reputation capital. Hughes and Thakor (1992) state that the change of law suit increases with offer price. 4.2 Price Stabilization Benveniste et al (1996) confirmed the price stabilization of Smith (1986) as a mechanism use by banks and investors. After a book-building, they could exaggerate the investors interest and overprice the IPO. For them, institutional investors who are active in book-building should be advantaged during the allocation. Chowdhry and Nanda (1996) instead consider retail investors as the principal beneficiaries of the price support. Schultz and Zaman (1994) and Hanley et al (1993) show evidence of general price support; and that price support seem to be accentuate for the weak IPOs. 5. Ownership and Control Two models analyze the link between underpricing of initial public offering and ownership and control. First, Booth and Chua (1996) and Brennan and Franks (1997) support the ownership dispersion hypothesis. They argue that firms are willing to underprice in order to have a diffuse ownership base and create a liquid market for their shares. Underpriced IPOs generate excess demand and create a large number of small shareholders. This is crucial for all IPOs as they aim for high participation of public in order to make difficult for outsiders to challenge management. They consider underpricing as a way to trespass managerial control by avoiding monitoring by an important outside shareholder. In contrary to the authors above, Stoughton and Zechners (1998) analysis suggests that underpricing is used to reduce agency costs by promoting monitoring. They observe in contrast to Booth, Chua, Brennan and Franks that the value can be ameliorate by allocating shares to a voluminous extern al investor that has the capacity to monitor managerial process. Stoughton and Zechner, model a book building regime with discretionary allocations; they assume managers keep intern the agency costs imposed to outside investors by lowering the price they are willing to pay for the shares. 6. Behavioral Explanations Loughran and Ritter (2002) suggest an explanation for IPO underpricing that emphasize on behavioral distortion between the decision-makers of the IPO Company, rather than between investors. They argue those issue firms accept the money left on the table during the large first-day returns because they summate the money loss due to underpricing with the wealth gain when prices rise in the after-market. They also assume that the decision-makers initial valuation beliefs are reflected in the mean of the indicative price range reported in the issuing firms IPO registration statement. This belief serves as a reference point against which the gain or loss from the outcome of the IPO can be assessed. The offer price for an IPO routinely differs from this reference point, either because the bank manipulated the decision makers expectations by low-balling the price range, or in reflection of information revealed during marketing efforts directed at institutional investors.