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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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    Media analysis

    Read the issue-related Wall Street Journal article titled "Inside Fumbled Facebook Offering."

    1. What key insights from the journal article and the study should reporters be aware of as they cover these issues?

    Study analysis

    Read the full study titled “The Variability of IPO Initial Returns.”

    1. What are the study's key technical term(s)? Which ones need to be put into language a lay audience can understand?
    2. Do the study’s authors put the research into context and show how they are advancing the state of knowledge about the subject? If so, what did the previous research indicate?
    3. What is the study’s research method? If there are statistical results, how did the scholars arrive at them?
    4. Evaluate the study's limitations. (For example, are there weaknesses in the study's data or research design?)
    5. How could the findings be misreported or misinterpreted by a reporter? In other words, what are the difficulties in conveying the data accurately? Give an example of a faulty headline or story lead.

    Newswriting and digital reporting assignments

    1. Write a lead, headline or nut graph based on the study.
    2. Spend 60 minutes exploring the issue by accessing sources of information other than the study. Write a lead (or headline or nut graph) based on the study but informed by the new information. Does the new information significantly change what one would write based on the study alone?
    3. Compose two Twitter messages of 140 characters or fewer accurately conveying the study’s findings to a general audience. Make sure to use appropriate hashtags.
    4. Choose several key quotations from the study and show how they would be set up and used in a brief blog post.
    5. Map out the structure for a 60-second video segment about the study. What combination of study findings and visual aids could be used?
    6. Find pictures and graphics that might run with a story about the study. If appropriate, also find two related videos to embed in an online posting. Be sure to evaluate the credibility and appropriateness of any materials you would aggregate and repurpose.

    Class discussion questions

    1. What is the study’s most important finding?
    2. Would members of the public intuitively understand the study’s findings? If not, what would be the most effective way to relate them?
    3. What kinds of knowledgeable sources you would interview to report the study in context?
    4. How could the study be “localized” and shown to have community implications?
    5. How might the study be explained through the stories of representative individuals? What kinds of people might a reporter feature to make such a story about the study come alive?
    6. What sorts of stories might be generated out of secondary information or ideas discussed in the study?