What is ‘Underpricing’
Underpricing is the pricing of an initial public offering (IPO) below its market value. When the offer price is lower than the price of the first trade, the stock is considered to be underpriced. A stock is usually only underpriced temporarily because the laws of supply and demand will eventually drive it toward its intrinsic value.
An IPO is a newly traded stock on the market and as such it may be newly introduced to investors. The proceeds of its sale are used by the company as capital for funding and future growth. The process for arriving at the offering price includes many factors. Quantitative factors are first considered; however, they are not the only factors that lead to the IPO price.
The main quantitative factors for valuing an initial public offering include the financials of the firm. Bankers review a firm’s sales, expenses, earnings and cash flow. In an IPO valuation pricing, the company’s earnings and expected earnings growth are key aspects of the price. In general, a company will typically trade at a price-to-earnings multiple that is comparable to its peers in the industry. The price-to-earnings multiple serves as a base level to start from when valuing the IPO price.
Additionally, an IPO may be priced based on marketability factors for its specific industry and the market as a whole. If bankers expect a high demand for the product, that will be factored into the price. Also, if there is a high demand for the IPO market in general at the time of the offering that will also help the price.
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