The Art of IPOs
By Logan Suba
If you are in an undergraduate finance class and hear about the next big company’s IPO, it may be worthwhile to question what is on the board about market efficiency.
The Mispriced IPO
For companies, the IPO is a huge undertaking that costs and risks a considerable amount, but can be profitable and secure the company’s reputation on the national or global stage. For investors, an IPO is a very risky investment as well, as IPO shares experience relatively heavier trading volume and larger price changes than an established company’s shares would. Where the two parties’ incentives converge is the final offering price. Finding a suitable price for an IPO is crucial to maximize funds raised for the company and investor enthusiasm surrounding the stock. Those who have taken traditional finance classes in the past might raise an eyebrow at the last sentence. Shouldn’t the price offered be the real value of the company? Shouldn’t the price be an accurate reflection of the combined intrinsic value of the company and its growth prospects? This is an attractive idea, but the reality is that IPOs are frequently underpriced or overpriced. Using this as a background, it may be worthwhile to approach this conundrum from a different perspective.
Behavioral Finance: A Primer
Behavioral finance is a discipline that aims to explain some market anomalies that conventional finance cannot fully explain. It was started by researchers Daniel Kahneman and Amos Tversky in the ‘70’s and has gained traction and credibility since. Instead of being rooted in math, statistics, or classical economics, behavioral finance draws largely from psychology,”behavioral science’s biases”, and heuristics to explain irrational decisions. For example, if an investor sees that the next big company is about to have an IPO, the logical thing to do would be to collect all the information he/she could and form a level-headed decision after reviewing it all. However, the impulse to be rational about the situation might be forgotten after the investor remembers that statistic that he/she heard about how companies in 2006 had an annual first day jump of 10.57%. According to the efficient markets hypothesis (the rival theory to behavioral finance), this investor would be an outlier. The Efficient Markets Hypothesis (or EMH for short) states that the price of a company's shares are an accurate reflection of all past and present information that is able to be obtained by the company. The investor’s actions were not conventionally rational, her risks were not properly identified, and she did not even get out her calculator. This is where behavioral finance shines, as it takes that investor in a supposed ‘hot’ state and attempts to decode why they are behaving so irrationally.
Herding: Wake up, Sheeple
Within the catalogue of biases that behavioral finance brings to the table, the herding bias pops out as an immediate candidate for an explanation on the part of investors. Herding occurs when investors do not act on their own calculations or intuition, but rather go along with what is hot. Conveniently, this played a huge part in the dot com bubble of the late 90’s, as companies sprung up out of nowhere with only catchy names and innovative ideas. Many of these companies would cause a great stir in the market when they would IPO and then would fade back to realistic prices or would fail. At the ‘pinnacle’ of the dot com bubble lies VA Software Company, whose IPO price was $30 but had a 698% first-day gain trading at $239.25, but then dipped back below $100 less than 5 months later. This can be explained from a herding standpoint as more and more investors clamored to get in on the dot com craze. This effect could even be seen in solid companies like Ebay whose IPO generated a massive 163.2% first day gain up to $29.83 from the offering price of $18. A simple Google search of failed dot com companies will bring up names like boo.com, flooz.com, and pseudo.com who were gone within a few years after overhyped IPO’s.
Loss Aversion: No Pain, No Gain
After reading about these spectacular first day jumps, you might be wondering why IPO underpricing is so widespread (14.8% from 1990 to 1998 according to Jay Ritter) given that the higher the price, the more money the company pockets. The simplified answer has to do with potential demand for shares and marketing. The IPO of a company is just as important for raising interest in their business model and growth prospects as it is for raising funds. A company that overpriced its IPO is considered to be greedy and is looked down upon (sometimes even ignored), while an underpriced company is looked at with awe and praised for its potential. When confronted with these two options, the company and its underwriters may come into contact with another bias known as Asymmetric Loss Aversion. This bias states that “losses hurt more than gains” (an amount lost will cause more cognitive strain than the same amount gained will excite) to the tune of two and a half times as much. This basically says that to take a bet where you would potentially lose ten dollars, the reward would have to be $25 to make it fair to the average person. With this in mind, the underwriters and the company itself may fall victim to this bias and go with the safer, more loss averse underpricing.
In Between the Cracks
The IPO mispricing issue is a conundrum that has plagued the finance community (making some rich and some frustrated) for years. Investing in IPOs remains a very interesting investment route that attracts attention and money, but the assets frequently behave in very erratic ways. Whether this is by design or due to some underlying inefficiency, they continue to defy the efficient market hypothesis and make headlines in the strangest ways. Before jumping into the fray of a new IPO, it is certainly worthwhile to include behavioral finance in your decision-making process.
About the Author: Logan SubA
As of December 2014
Logan Suba is a senior finance major at Pace University. His interests include risk management, behavioral finance, banking, and corporate finance. In his free time, Logan enjoys, hiking, cycling, and tolerating the MTA. He currently lives in Bushwick Brooklyn