What Is Underpricing?

What Is Underpricing?

Let me explain underpricing directly: it's the practice of setting the initial public offering (IPO) price of a stock below its true market value, often to stimulate demand and ensure a successful launch.

Underpricing happens when you list an IPO at a price below its real value in the stock market. If a new stock closes its first day of trading above the set IPO price, you can consider it underpriced.

This underpricing is short-lived because investor demand will push the price upwards to its actual market value.

Understanding Underpricing

An initial public offering, or IPO, introduces a new stock for public trading on a stock exchange, with the goal of raising capital for the company's future growth.

When determining the offering price, you start with quantitative factors—these are the hard numbers on cash flow, both real and projected.

Here's what you need to know: an IPO might be underpriced deliberately to boost demand and encourage investors to take a risk on a new company. It could also happen accidentally if the underwriters underestimated the market demand for this company's stock. In either case, the underpricing is measured by the difference between its first-day closing price and the set IPO price.

There are two opposing goals here. The company's executives and early investors aim to price the shares as high as possible to raise maximum capital and reward themselves generously. On the other hand, the investment bankers advising them might prefer a lower price to sell more shares, since higher volume translates to higher trading fees for them.

IPO Pricing Factors

IPO pricing isn't an exact science, so underpricing an IPO is equally imprecise. The process combines facts, projections, and comparables. You look at quantitative factors like the company's financials, including current sales, expenses, earnings, and cash flow, with projected earnings also playing a key role.

You aim for an IPO price that reflects a price-to-earnings (P/E) multiple comparable to the company's industry peers. Additionally, consider the size of the current and near-future market for the product or service the company produces, along with the marketability of the stock in the current economic environment.

Why Underprice?

In theory, any IPO that rises in price on its first trading day was underpriced, whether deliberately or by accident. The shares might have been underpriced on purpose to boost demand, or the underwriters simply underestimated investor interest.

Remember this important point: overpricing is much worse than underpricing. If a stock closes its first day below the IPO price, it's labeled a failure.

An IPO can be underpriced if its sponsors are genuinely uncertain about how the stock will be received. In the worst case, the stock price will quickly climb to what investors think it's worth, rewarding those willing to take a risk and pleasing the company's executives.

That's far better than the stock price falling on day one and the IPO being called a failure. Whether underpriced or not, once the IPO debuts, the company becomes publicly traded, owned by its shareholders, and shareholder demand will determine the stock’s value in the open market from there.