The variability of returns on initial public offerings (IPOs)

 
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A company’s decision to “go public” and move forward with an initial public offering of stock, or IPO, is typically driven by the desire to raise capital and expand its business. The company’s shares are then publicly traded on the market, and its management becomes responsible to shareholders. But as Facebook’s May 2012 IPO showed, the early days of issuing stock can often be rocky, and history suggests that early IPOs and the performance of new shares are frequently plagued by a number of variables.

A 2010 study published in the Journal of Finance, “The Variability of IPO Initial Returns,” examines the performance of 8,759 IPOs from 1965 to 2005. The researchers, from Penn State, Loyola Marymount and the University of Rochester, propose a “new metric for evaluating the pricing of IPOs in traditional firm-commitment offerings” by analyzing the volatility of initial returns to IPO stocks.

The study’s findings include:

  • There is indeed “considerable volatility in initial returns.” Stocks are frequently underpriced and the “range of the forecast (or pricing) errors is huge.”
  • Underpricing averaged 22% between 1965 and 2005, but this can be misleading, as only about 5% of the underpriced IPOs fall in the 20% range. Nearly a third of the initial returns were negative, meaning that the IPO was overpriced.
  • These trends suggest that “underwriters have great difficulty in accurately valuing the shares of companies going public through IPOs. The process of marketing an issue to institutional investors, for example, during the road show, appears unable to resolve much of the uncertainty about aggregate market demand for the stock of IPO firms.”
  • Pricing errors are actually more likely to occur for stock issues for which the most early investor “learning” occurs, with large price updates during the registration period (the time when the IPO is initially marketed to investors). In other words, IPOs that feature an intense marketing period are associated with more volatility and thus a less accurate initial share price.
  • The problems are particularly acute for technology firms: “Consistent with the notion that the complexity of the pricing problem in traditional firm-commitment offerings contributes to IPO initial return volatility, we report greater pricing errors (dispersion of initial returns) when a larger fraction of high information asymmetry firms (young technology firms) goes public and during hot markets, particularly the IPO bubble of the late 1990s.”

“Our results raise serious questions about the efficacy of the firm-commitment IPO underwriting process,” the study concludes, “as the volatility of the pricing errors reflected in initial IPO returns is extremely large, especially for firms with high information asymmetry and during hot market periods. We conjecture that alternative price discovery mechanisms, such as auction methods, could result in much more accurate price discovery in the pretrading period for IPO companies.”

Tags: economy, entrepreneurship

    Writer: | Last updated: May 23, 2012

    Citation: Lowry, Michelle; Officer, Micah, S.; Schwert, G. William. “The Variability of IPO Initial Returns,” The Journal of Finance, April 2010, Vol. 65, Issue 2, 425–465. doi:10.1111/j.1540-6261.2009.01540.x.
     

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